The Banking Law Journal

Transcription

1 The Banking Law Journal Established 1889 AN A.S. PRATT & SONS PUBLICATION JULY/AUGUST 2008 HEADNOTE: AN HSA ROADMAP Steven A. Meyerowitz HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL FOR BANKS AND OTHER FINANCIAL INSTITUTIONS John R. Hickman, Ashley Gillihan, and Joseph Yesutis FDIC ACTION MAY OPEN THE DOOR TO FURTHER DEVELOPMENT OF THE COVERED BOND MARKET Mark I. Sokolow and Richard D. Simonds, Jr. and Eleni Zanias BANKING BRIEFS Donald R. Cassling

2 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL FOR BANKS AND OTHER FINANCIAL INSTITUTIONS JOHN R. HICKMAN, ASHLEY GILLIHAN, AND JOSEPH YESUTIS This article provides a roadmap to assist financial institutions offering health savings account ( HSA ) products or services to better navigate and understand the applicable HSA operating rules under the various tax and employee benefit law requirements. The discussion begins with a high-level overview of HSA tax and related employee benefit legal requirements (the PDQ of HSA Requirements ). This is followed by an in-depth drill down on each of these HSA Requirements. The article concludes with a quick reference chart summarizing more familiar territory for bank custodians and trustees i.e., the more traditional banking legal requirements that may apply to a financial institution s HSA operations. In Health Savings Accounts and the Convergence of Healthcare and Banking, 1 the authors describe the convergence of healthcare and banking services resulting, in large part, from the race to service health savings accounts (or HSAs ). For banks, the ultimate prize sought is a new source of retail deposits and investments (along with resulting fee revenue) that were previously available almost exclusively to health insurers. Unfortunately, as the old adage goes, with great opportunity comes great responsibility. Proper functionality of an HSA involves an elaborate interplay of compliance concerns under numerous legal regimes including tax, This article is published in the July/August 2008 issue of The Banking Law Journal. Copyright 2008 ALEX esolutions, Inc. 1

3 BANKING LAW JOURNAL healthcare, employment, banking and securities. As a result, the various financial institutions involved in defining and delivering an HSA to corporate clients and individual consumers (e.g., banks, health insurers, securities firms) must be mindful of their respective, and often competing, legal and regulatory compliance obligations. For banks, offering HSA products and services implicates sufficiently significant regulatory compliance concerns. Prior to jumping in, management should satisfy itself that the offering is consistent with existing bank policies (e.g., Information Security, Privacy, Vendor Management, Affiliate Transactions, BSA/OFAC, etc.). In addition, a bank should be mindful of the impact of an HSA program (with highly transactional accounts) on its reserve requirements under the Federal Reserve Board s Regulation D, and its deposit insurance obligations under the Board s Federal Deposit Insurance Act. Moreover, disclosure obligations are critical. An HSA is a consumer account, and as such, will be subject to an account agreement with the consumer whereby the bank will establish a relationship with the consumer independent of that between the consumer and its health plan. This raises consumer identity verification concerns under the Bank Secrecy Act and OFAC, as well as consumer privacy protections under state and federal law. The features of the HSA will also dictate necessary disclosures in the consumer-facing documentation. The manner by which the account can be accessed, for example, may implicate fund transfer rules, such as card association rules, ACH, Fedwire, and the Electronic Funds Transfer Act. If the account includes a self-directed invested component, securities-related disclosures will also be required. The foregoing compliance concerns are all federal law issues; these are in addition to the numerous state level concerns, such as The authors are attorneys with Alston & Bird, LLP, a national law firm. John Hickman is partner in charge of Alston& Bird s Health Benefits Practice. Ashley Gillihan is counsel in the group and Joseph Yesutis is counsel in the Financial Services and Products Group. Together they provide an integrated approach to addressing the HSA and health benefit plan compliance issues of financial institutions, health plans, and employers. Laurie Kirkwood, an associate in the Atlanta office of Alston & Bird, assisted in editing this article. The authors can be reached at [email protected], [email protected], and [email protected], respectively. 2

4 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL state-specific property laws and escheatment rules. Taken together, the foregoing illustrates how a health care provider, bank, and securities broker/dealer will each need to comply with similar, often over-lapping, compliance and disclosure obligations. In some cases, these compliance responsibilities can be delegated by contract, but the utility of this strategy will depend largely on the quality of a bank s HSA service partners, and in any event, is unlikely to provide comfort in the event of program-wide compliance failures. This article provides a roadmap to assist those financial institutions offering HSA products or services to better navigate and understand the applicable HSA operating rules under the various tax and employee benefit law requirements. The discussion begins with a high-level overview of HSA tax and related employee benefit legal requirements (the PDQ of HSA Requirements ). This is followed by an in-depth drill down on each of these HSA Requirements. The article concludes with a quick reference chart summarizing more familiar territory for bank custodians and trustees i.e., the more traditional banking legal requirements that may apply to a financial institution s HSA operations. PDQ OF HSA REQUIREMENTS From the 30,000 foot view, an HSA is a tax-advantaged healthcare expense reimbursement vehicle that has many of the earmarks of a checking account, investment vehicle and health plan benefit account (sometimes called a defined contribution account ). HSAs often prove disconcerting for banks and financial institutions because they do not fit neatly into any one of those categories as either a deposit product or a trust/investment product. HSAs are subject to a complex maze of tax and benefits-related rules and regulations. The primary purpose of the HSA is to provide a tax-advantaged means for reimbursement of current and future medical expenses. The majority (but not all) of the tax requirements for establishing and maintaining an HSA are set forth in Internal Revenue Code ( Code ) Section 223. Code Section 223 was added to the Code in late 2003 by Section 1201 et seq. of the Medicare Prescription Drug Improvement and Modernization Act of 2003 (the 2003 Act ). 2 The 2003 Act simply built the framework for HSAs and left the details to the Internal Revenue Service (the IRS ). Fortunately, the IRS 3

5 BANKING LAW JOURNAL has charged full steam ahead and has issued numerous rounds of HSA specific guidance in the form of Revenue Rulings, Notices and regulations (collectively referred to as IRS Guidance ). 3 In addition, Congress made several improvements to HSAs when it enacted the Health Opportunity Patient Empowerment Act of 2006 (the 2006 Act ). 4 The improvements made by the 2006 Act were generally effective January 1, Since employers often assist their employees with establishing HSAs (e.g., by sponsoring qualifying high deductible health plans, facilitating the establishment of HSAs for employees who enroll in the high deductible health plan, and/or contributing to HSAs established by their employees), the Department of Labor ( DOL ) has also issued guidance, Field Assistance Bulletins and , that addresses the applicability of the Employee Retirement Income Security Act of 1974 ( ERISA ) to HSAs. 5 NOTE: The IRS and DOL guidance is addressed throughout this article; however, much of the HSA-related guidance can be found at: Last but not least, HSAs are trusts or custodial accounts subject to a variety of somewhat more familiar state and federal banking laws (e.g., the Patriot Act) as well as state laws applicable to trusts and custodial accounts (e.g., state unclaimed property laws). Needless to say, understanding the basic tax operating rules for HSAs is of paramount importance to effectively establishing and maintaining an HSA program. The following is a general overview of the fundamental operating rules: Only Eligible Individuals May Establish and Make Tax-Advantaged Contributions to an HSA. An individual is an Eligible Individual for HSA purposes during any month that he or she satisfies the following four conditions on the first day of the month: The individual is covered under a qualifying high deductible health plan ( HDHP ); The individual is not covered under any non-hdhp unless the coverage is limited to one or more of the following permitted types of coverage: preventive care, permitted insurance, and/or permitted coverage (the 3 Ps discussed in more detail below). 4

6 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL The individual cannot be claimed as a dependent of another taxpayer; and The individual is not entitled to Medicare. Once established, the HSA belongs to the Eligible Individual for whom it was established ( Account Beneficiary or Account Holder ) and the Account Beneficiary s interest in that HSA is non-forfeitable. HSA trustees/custodians have no obligation to verify whether an individual is an Eligible Individual. HSAs are Qualified Trusts (or Custodial Accounts) Established with a Qualified Trustee (or Custodian). A trust/custodial account and the associated trustee/custodian must satisfy certain requirements before the account qualifies as a tax-advantaged HSA. Banks, certain insurance companies and any other entities that have already been approved by the IRS to be an IRA or Medical Savings Account ( MSA ) trustee/custodian are automatically approved to be an HSA trustee/custodian. Any other entity may become an HSA custodian/trustee to the extent that they apply to the IRS and satisfy the rather stringent requirements. In addition, the HSA must comply with any applicable federal and state laws relating to trusts or custodial accounts. For example, banks must comply with the Patriot Act when establishing an HSA. Also, state escheat and unclaimed property laws may apply. Contributions to the HSA Are Tax-Favored to the Extent Certain Conditions Are Satisfied. Contributions to the HSA may be made by the Account Beneficiary or anyone else on the Account Beneficiary s behalf. After-tax HSA contributions by an Account Beneficiary or any other person on the Account Beneficiary s behalf are generally deductible by the Account Beneficiary above the line (i.e., a deductible expense without regard to whether the Account Beneficiary itemizes on his/her tax return). Alternatively, Account Beneficiaries may contribute to their HSAs with pre-tax salary reductions made through their employer s Code Section 125 cafeteria plan to the extent that the employer has amended its cafeteria plan to permit HSA contributions. Employer contributions to an 5

7 BANKING LAW JOURNAL Employee s HSA are generally excluded from the Account Beneficiary s gross income (i.e., they are tax free). Interest and/or Investment earnings from HSA contributions generally accrue tax-free. In order for the contributions to be tax-advantaged (i.e., deductible or tax-free), the contributions must satisfy two conditions: 1) the contributions must be made by or on behalf of an Eligible Individual and 2) the contributions from all sources during the taxable year (generally, the calendar year) cannot exceed the maximum annual contribution established by Code Section 223 for that individual. Contributions in excess of the individual s maximum contribution amount are generally subject to adverse tax treatment except in certain limited situations. HSA trustees/custodians are required to report the total amount of contributions received during the year to the IRS and the Account Beneficiary on IRS Form 5498-SA. Distributions From the HSA Are Tax Free if for Qualified Medical Expenses. Distributions from an HSA are tax-free if the distributions are used for qualified medical expenses. Such distributions are tax free even if the Account Beneficiary has ceased to be an Eligible Individual (e.g., because they no longer have qualifying coverage, or become covered under a non-hdhp plan). Unlike the Health FSA and/or HRA, distributions from an HSA for non-qualifying medical expenses are also permitted and do not otherwise disqualify the general tax-advantaged status of the HSA; however, such non-medical expense distributions are generally subject to income and excise taxes but for a few exceptions. HSA trustees/custodians must report the total distributions made from an Account Beneficiary s HSA during the year to the IRS and the Account Beneficiary on IRS Form 1099-SA. HSA trustees/custodians have no obligation to verify whether the distributions are for medical expenses. 6 HSAs Are Generally Not Subject to ERISA (if structured properly). HSAs are generally not considered to be employer sponsored plans subject to the reporting, disclosure and fiduciary requirements of the Employees 6

8 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Retirement Income Security Act of 1974 ( ERISA ) to the extent that the employer satisfies the safe harbor requirements set forth in Field Assistance Bulletins ( FAB ) and HSAs Are Subject to the Prohibited Transaction Requirements Set Forth in Code Section 408 and Code Section There are certain transactions entered into by an HSA Account Beneficiary and/or other parties associated with the HSA ( Disqualified Persons, such as the trustee/custodian or other HSA service provider) that will result in adverse tax consequences for the Account Beneficiary and/or the other Disqualified Person (i.e., the HSA custodian). For example, an Account Beneficiary may not use the HSA as security for a loan. Other somewhat standard banking arrangements in the banking industry may also constitute a prohibited transaction in certain situations such as overdraft protection or lines of credit offered in conjunction with an HSA. Also, Account Beneficiaries and Disqualified Persons will engage in a prohibited transaction to the extent that the compensation paid to HSA service providers (such as trustee/custodians or investment advisors) is unreasonable and/or for unnecessary services. HSA TAX REQUIREMENTS FOR THE DETAIL-ORIENTED This section addresses who is eligible for HSA tax benefits, the requirements for an HSA custodial (or trust) document, and the tax rules associated with HSA contributions and distributions. While the HSA Account Holder is generally responsible for ensuring that these requirements are satisfied, financial institutions and banks that serve as HSA custodians and trustees must be familiar with these requirements in order to adequately address customer inquiries. Eligibility This sub-section describes who is eligible to establish an HSA and make/receive tax-favored contributions to the HSA. 7

9 BANKING LAW JOURNAL Planning Pointer: Do not conflate the rules for making tax-advantaged contributions to an HSA with receiving taxadvantaged distributions from the HSA. The former is contingent on being an Eligible Individual (as discussed below) and the latter is not. Definition of Eligible Individual Any individual who is an Eligible Individual may establish an HSA and make/receive tax-favored contributions to the HSA during a month. 7 An individual is an Eligible Individual for any month if he or she satisfies all four of the following conditions on the first day of the month: The individual is covered under one or more qualifying HDHPs. The individual is not covered under any non-hdhps unless the coverage provided under the non-hdhp is limited to one or more of the three types of allowable coverage (the 3 Ps ): permitted coverage, permitted insurance and/or preventive care (see below for a more detailed discussion of the 3 Ps). An individual must analyze all health plans under which the individual is covered to determine if he or she is an Eligible Individual, including but not limited to individually issued insurance policies and group plans sponsored by the individual s spouse s employer. The individual is not eligible to be claimed as a dependent on anyone else s tax return. It does not matter whether the individual is actually claimed as a dependent or not only that the individual could be claimed as a dependent on someone else s tax return. The individual is not entitled to Medicare (due to age or disability). There is a subtle difference between eligibility for Medicare and entitlement to Medicare. For example, an individual who is age 65 or older is eligible for Medicare. Whether that person is entitled to Medicare benefits depends on a number of factors. If the individual has applied for Social Security retirement income benefits on or before turning age 65, then the individual is automatically enrolled in Medicare and is therefore 8

10 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL entitled to Medicare benefits (and thus no longer an Eligible Individual). However, if the individual has not applied for Social Security retirement income benefits by the time he/she turns age 65, then he/she is not automatically enrolled in Medicare benefits; he or she must affirmatively enroll. If he or she doesn t affirmatively enroll in Medicare, then he/she is only eligible for Medicare and may still qualify as an Eligible Individual (provided the individual satisfies all of the other conditions). 8 Planning Pointer: As noted above, Eligible Individual status is determined on the first day each month. For example, an individual who does not satisfy all four of the above mentioned conditions until June 15 does not become an Eligible Individual until July 1 (assuming all four of the requirements are still satisfied on July 1). Likewise, an individual who satisfies all four of the requirements on June 1 but ceases to satisfy one or more of the requirements on June 15 (e.g., the individual ceases to be covered under a HDHP) remains an Eligible Individual through June 30. Ultimately, it is the individual s responsibility to ensure that he/she is an Eligible Individual. IRS guidance indicates that trustees/custodians may, but do not have to, require verification of eligibility status. 9 Employers, on the other hand, have some, albeit limited, verification responsibility if they contribute to their employees HSAs. According to the IRS, employers who contribute to their employees HSAs are responsible for verifying the following: If the employee is enrolled in an HDHP sponsored by the Employer, the Employer must ensure that the HDHP satisfies the applicable requirements of Code Section 223; and That the individual is not covered under any non-hdhps sponsored by that employer. 10 The employer is not responsible for analyzing coverage maintained by the employee through other sources, such as through a spouse s employer. 9

11 BANKING LAW JOURNAL Definition of Qualifying High Deductible Health Plan ( HDHP ) An HDHP is any health plan (self-funded or fully-insured by an insurance carrier) other than a Health Reimbursement Arrangement ( HRA ) or Health Flexible Spending Account ( Health FSA ) that meets each of the following requirements: 11 The plan imposes an annual deductible that is not less than the minimum deductible established by the statute (the Statutory Minimum Annual Deductible ) for single and family coverage. The Statutory Minimum Annual Deductible for 2008 is $1,100 for self-only coverage and $2,200 for family coverage. 12 These amounts are indexed for inflation. 13 The plan s annual out-of-pocket expense maximum cannot exceed the maximum out-of-pocket expense amount established by the statute (the Statutory OOP Maximum ). The Statutory OOP Maximum for 2008 is $5,600 for self-only coverage and $11,200 for family coverage. These amounts are indexed for inflation. Planning Pointer: The deductible may be higher than the Statutory Minimum Annual Deductible; however, the deductible, combined with other out-of-pocket expenses, cannot exceed the Statutory OOP Maximum. What is the difference between self-only and family coverage? Family coverage is any coverage other than self-only coverage. Thus, categories such as employee plus one, employee plus spouse and employee plus family all constitute family coverage subject to the Statutory Minimum Annual Deductible for family coverage. If an individual has family coverage, the IRS has clarified that no amounts can be paid by the HDHP for any family member (other than for the 3 Ps) until the Statutory Minimum Annual Deductible for family coverage has been satisfied. 14 Thus, family coverage under a health plan does not qualify as an HDHP in 2008 if there is an individual (or embedded ) deductible 10

12 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL for any family member lower than $2,200. For example, a health plan that has a $2,200 deductible for family coverage but provides reimbursement of covered expenses for any member of the family once that family member has incurred $1,100 in expenses is not a qualifying HDHP because the plan pays expenses for a covered family member before the Statutory Minimum Annual Deductible for family coverage has been satisfied. Planning Pointer: Prior to the 2006 Act, the HDHP s deductible also impacted the maximum annual HSA contribution amount. The maximum amount that could be contributed to an HSA each year was the lesser of (i) the deductible or (ii) the applicable annual maximum contribution amount set forth in Code Section 223 (this latter amount referred to herein as the Statutory Maximum Annual Contribution ). However, the 2006 Act eliminated the lesser of the deductible rule so that the maximum annual contribution amount is now equal to the Statutory Maximum Annual Contribution amount without regard to the HDHP s deductible. Expenses that must be applied toward the HDHP s out-of-pocket maximum include the following: The deductible, Co-payments (even if not applied toward the deductible), and Co-insurance amounts. 15 Expenses that do not have to be applied toward the out-of-pocket maximum include the following: HDHP premium amounts paid by the individual, 16 Amounts that exceed the plan s reasonable and customary limits (or sometimes referred to as the usual and customary limit), 17 Penalty amounts imposed by the Plan for failing to satisfy certain plan 11

13 BANKING LAW JOURNAL requirements, such as pre-authorization. 18 The penalty amounts that are excluded from the out-of-pocket expense maximum include increased coinsurance amounts resulting from failure to satisfy the plan s requirements. Amounts in excess of the annual or lifetime limit imposed by the plan so long as such limits are reasonable. Expenses for services or treatments that are specifically excluded by the plan (e.g., expenses that are not medically necessary or that are investigational or experimental). Cost of Living Adjustments. The Statutory Minimum Annual Deductible and the Statutory OOP Maximum are indexed for inflation using annual cost-of-living adjustments ( COLAs ). 19 The 2006 Act requires the IRS to issue COLAs for a given year no later than June 1 of the preceding year. Special Rule for Network Plans. If the HDHP is a network plan, the HDHP s higher annual deductible limit and out-of-pocket maximum for out-of-network expenses are disregarded. Consider the following example: Plan A imposes a $1,100/$2,200 deductible (single and family coverage respectively) for in-network services, but a $5,500/$11,000 deductible for out-of-network services. In this example, the plan still satisfies the Statutory Minimum Annual Deductible, even though the Plan s out-ofnetwork deductible exceeds the Statutory OOP Maximum, because the out-of-network maximum is disregarded when determining whether the plan satisfies the statutory requirements. Non-HDHP Coverage That Does Not Disqualify an Individual: the 3 Ps An individual generally cannot have other non-hdhp coverage and qualify as an Eligible Individual unless that coverage is limited to one or more of the 3 Ps. Likewise, an HDHP cannot provide any coverage below the 12

14 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Statutory Minimum Annual Deductible except coverage limited to the 3 Ps. The 3 Ps include the following: Permitted coverage is any of the following types of coverage, whether provided through insurance or otherwise: accident, disability, dental care, vision care, or long-term care. Thus, for example, automobile medical coverage for accidents or a school or sports accident policy should be permissible even if some medical expenses are covered. Permitted insurance is insurance coverage for which substantially all of the coverage relates to liabilities incurred under workers compensation law; tort liabilities; liabilities relating to ownership or use of property (e.g., homeowner or auto insurance); insurance for a specified disease or illness (e.g., cancer insurance); and insurance that pays a fixed amount per day (or other period) of hospitalization (e.g., hospital indemnity insurance). 20 With the exception of certain state mandated benefits (e.g., workers compensation coverage), permitted insurance must be offered through a commercial insurance contract (i.e., it cannot be self-funded). 21 Preventive Care is, for HSA purposes, any service or treatment that falls within the safe harbor definition set forth in Notice Included in that safe harbor are the following: periodic health evaluations (and the tests and diagnostic procedures ordered in conjunction with such evaluations); well-baby and/or well-child care; immunizations for adults and children; tobacco cessation and obesity weight loss programs; and various screening devices (IRS provided a list of permissible screening devices in Notice ). Preventive care does not, however, generally include services or treatments intended to treat an existing condition unless they are ancillary treatments associated with a screening procedure that would be unreasonable or impractical to perform separately. 22 Impact of Participation in a Health FSA and/or HRA on Eligible Individual Status In Rev. Rul , the IRS specifically addressed the impact of participation in a Health FSA and/or Health Reimbursement Arrangement 13

15 BANKING LAW JOURNAL ( HRA ) 23 on HSA eligibility. Most Health FSA and/or HRAs provide reimbursement/payment of general medical care expenses (as defined in Code Section 213(d), subject to limited exceptions). These are generally called General Purpose Health FSAs and/or HRAs. Participation in a General Purpose Health FSA and/or HRA will disqualify an otherwise Eligible Individual. An individual may, however, qualify as an Eligible Individual and still participate in a Health FSA and/or HRA at the same time if the Health FSA and/or HRA coverage is limited as set forth in Rev. Rul For example, reimbursements are limited only to vision, dental, and/or preventive care expenses (typically referred to as a limited purpose Health FSA ) or to expenses incurred after the Statutory Minimum Annual Deductible has been satisfied (or a combination of the two). Requirements for HSA Trust/Custodial Document In order to establish an HSA, an Eligible Individual must enter into a trust or custodial agreement with a qualified HSA custodian/trustee. While, in many ways, HSAs operate similar to common banking vehicles such as trusts or individual retirement arrangements ( IRAs ), HSAs are, by design, more transactional in nature (requiring frequent account access), operating more like a deposit account than a trust account. This section describes the applicable requirements for being a trustee/custodian and for establishing an HSA. HSA is a Qualified Trust (or Custodial Account) General Overview. An HSA is a written trust or custodial account created or organized in the United States as a health savings account exclusively for the purpose of paying the qualified medical expenses of the Account Beneficiary. The governing instrument creating the trust must address the following requirements: The HSA contributions must be in cash (except for rollover contributions, which are discussed in more detail below). 14

16 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL The trustee cannot accept contributions during a year (other than rollover contributions) in excess of the statutory maximum contribution amount associated with family coverage, plus catch-up contributions for those age 55 or older (without regard to the actual contribution maximum for the Account Beneficiary). The trustee of the trust is a bank, an insurance company, or another person who demonstrates to the satisfaction of the Secretary of the Treasury that the manner in which such person will administer the trust will be consistent with the HSA requirements. No part of the trust can be invested in life insurance contracts. The assets of the trust cannot be commingled with other property except in a common trust fund or common investment fund. The interest of an individual in the balance in his account must be nonforfeitable. 24 Except as noted above, the statute does not specify the terms that must be included in an HSA trust or custodial document. The IRS has issued a prototype HSA document that can serve as a safe harbor document setting forth the necessary HSA provisions. You can find a copy of the model custodian document at and the model trust document at Most custodians/trustees use the IRS document as a starting point, and then specifically address additional issues related to the custodial arrangement (e.g., electronic communication, fees, beneficiary designations). Once established, the HSA trust or custodial account belongs to the Account Beneficiary and the Account Beneficiary s interest in the account is non-forfeitable. For example, assume Acme contributes $1,200 to Employee A s HSA on January 1, On February 1, 2008, Employee A terminates employment. Acme can not recover the funds deposited to former Employee A s HSA. The non-forfeitable requirement has posed client relations issues for HSA trustee/custodians that have entered into an agreement with an employer, as is often the case, to establish HSAs for its eligible employees and to accept contributions from the employer on behalf of those employees. In 15

17 BANKING LAW JOURNAL many instances, the employer will erroneously make a contribution to the HSA of an employee or former employee. Read literally, this rule would not permit the HSA trustee/custodian to return that contribution to the employer once it has been allocated to the employee s HSA. Additional guidance from the IRS regarding contribution corrections is expected in the near future. Can an individual have more than one HSA? Yes, but the maximum annual contribution amount applies to the aggregate contributions made to all HSAs of an individual. HSA contribution requirements are set forth in more detail below. Can spouses have a joint HSA? Unlike traditional checking or deposit accounts, spouses cannot establish a joint HSA. 25 Although joint HSAs are not permitted, one spouse may receive a distribution from his HSA for the qualified medical expenses of his legal spouse, even if both have separate HSAs, so long as the expense is not reimbursed by both HSAs. 26 If both spouses establish an HSA, there are limits on the amount of contributions that each can make to his/her HSA (see below for more discussion on the special married couple contribution rule). The HSA Must Be Maintained by a Qualified Trustee or Custodian General Overview Only qualified trustees or custodians may maintain the HSA trust. There are currently three types of entities that are automatically deemed by statute to be a qualified HSA trustee or custodian: Banks (or other similar institutions as described in Code 408(n) such as an insured credit union or other corporation that is subject to the supervision of the Commissioner of Banking in the state in which it is incorporated); Any insurance company as defined in Code Section 816. Interestingly, the statute indicates that only life insurance companies can automatically 16

18 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL qualify as HSA trustees; however, recent guidance from the IRS indicates that health insurance companies can also automatically qualify as an HSA trustee/custodian. 27 Any other entity that has already been approved by the IRS to be a qualified IRA or MSA trustee/custodian. All other entities who wish to become a qualified HSA trustee or custodian and who do not fall into one of the three automatic categories identified above must apply to the IRS to become an HSA trustee or custodian in accordance with the procedures for non-bank custodians established under the rules for individual retirement accounts, or IRAs, in the Code. 28 How does a non-bank/financial institution apply to become a qualified HSA trustee/custodian? In accordance with Treas. Reg (e), the applicant must submit a written application to the Commissioner of the IRS showing that the applicant can satisfy the following three general requirements: Fiduciary ability, Capacity to account, and Fitness to handle funds. 29 What is the difference between a custodian and a trustee? For HSA purposes there is very little difference between a trustee and custodian. The primary difference is the level of fiduciary responsibility between the two. The following is an excerpt from the Frequently Asked Questions from the Department of Treasury Web site: The differences between a custodian and a trustee are minor. A trust is a legal entity under which assets are actually owned and held on behalf of a beneficiary. The trustee has some level of discretionary fiduciary authority over the assets of the fund. 17

19 BANKING LAW JOURNAL The trustee must exercise that authority in the best interests of the beneficiary. A custodial arrangement, on the other hand, is like a trust, but the custodian simply holds the assets on behalf of the owner of the assets. Other than holding the assets and doing as the owner orders, the custodian has no fiduciary obligations to the owner. The determination of what constitutes a trust or custodial arrangement is a determination made under state law. 30 While unimportant for tax purposes, the ability to exercise fiduciary powers (even limited fiduciary powers) may be very important for bank regulatory purposes. The American Banker s Associate recently published an article on its Web site that discusses the differences between deposit, trust and custodial accounts. A copy of that article is at Press+Room/032008AssetSafety.htm. HSA Contributions This section addresses issues related to HSA contributions such as timing of contributions and maximum amounts. As noted herein, custodians/trustees are responsible for ensuring that annual contributions do not exceed the Statutory Maximum Annual Contribution associated with family coverage (without regard to the individual s actual coverage level). Source and Timing of HSA Contributions General Overview HSA contributions may come from anybody, including, but not limited to, the Eligible Individual s employer and/or the Eligible Individual so long as the contributions are made by or on behalf of an Eligible Individual and do not, in the aggregate, exceed the Account Beneficiary s maximum annual contribution amount ( Annual Contribution Limit ). 31 Note that the Annual Contribution Limit is different from, but is related to the Statutory Maximum Annual Contribution, explained in more detail below. Except for rollover contributions, contributions must be made in cash

20 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Eligible individuals may contribute with after-tax contributions or, if the employer s cafeteria plan permits, with pre-tax salary reductions. 33 Employer contributions are excluded from income and employment taxes while contributions by Eligible Individuals and other persons on their behalf are deductible by the Eligible Individual above the line to the extent the contributions from all sources (other than rollover contributions) do not exceed the Statutory Maximum Annual Contribution amount. Since the deduction is an above-the-line deduction, the Eligible Individual may deduct the contribution without regard to whether he/she itemizes on his/her tax return. The following is a quick use chart regarding the tax status of contributions to the HSA: Type of Contribution Employer Contribution Tax Status Tax Free under Code Section 106 Employee Pre-tax Salary Reduction Tax Free if made through employer s Code Section 125 plan Employee Contribution (after-tax) Deductible above the line by the Account Beneficiary Contribution from any other source May be includable in income to the individual, but then deductible above the line by the Account Beneficiary An Account Beneficiary may also fund his/her HSA through one or more of the following methods: Rollover Contributions and Transfers An Eligible Individual may make rollover contributions to his/her HSA. Rollover contributions are contributions to an HSA attributable to a distribution from another HSA or Archer Medical Savings Account ( MSA ). Rollover contributions are generally not counted toward the Annual 19

21 BANKING LAW JOURNAL Contribution Limit. 34 Rollovers may be in the form of a distribution from an HSA to the Account Beneficiary or a direct trustee-to-trustee transfer. Any distribution from an HSA that is not for reimbursement/payment of qualified medical expenses is not subject to the applicable income or excise tax so long as it rolled over to another HSA within 60 days of the Account Beneficiary receiving the distribution in cash from the other HSA or MSA. 35 Generally, rollover contributions may be made once every 12 months (measured from the date of the distribution from the other HSA or MSA). Direct trustee-totrustee transfers (from one HSA trustee/custodian to another), however, are not subject to the 12 month limitation. 36 Direct trustee-to-trustee transfers can presumably be made by issuing a check to the Account Beneficiary that is made out to the other trustee/custodian. Interestingly, while Eligible Individuals are permitted to make rollover contributions, trustee/custodians are not required to accept rollover contributions. 37 On the other hand, trustees/custodians cannot restrict an Eligible Individual s ability to rollover amounts from the HSA maintained by that trustee or custodian. 38 Prior to the 2006 Act, No amounts could be rolled over from an IRA, Health FSA and/or HRA. 39 However, the 2006 Act specifically allows a once-in-a-lifetime rollover from an IRA ( Qualified HSA Funding Distribution ) and/or a Health FSA/HRA ( Qualified HSA Distribution ). Qualified HSA Distributions and Qualified HSA Funding Distributions are discussed in more detail below. Qualified HSA Distributions (aka transfer from Health FSA and/or HRA) The 2006 Act amended Code Section 106 to allow HRA and/or Health FSA participants to make a once in a lifetime transfer of unused Health FSA and/or HRA funds to an HSA without disqualifying the Health FSA and/or HRA. Qualified HSA Distributions are treated very much like direct trusteeto-trustee transfers in that they are not counted toward the Annual Contribution Limit and they must be made direct from the employer to the trustee. Qualified HSA Distributions are tax free to the extent the Account Beneficiary remains an Eligible Individual during the Qualified HSA Distribution testing period, which includes the month in which the 20

22 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Qualified HSA Distribution is made and the 12 months following that month. The Qualified HSA Distribution is included in income and subject to a 10 percent excise tax if the Account Beneficiary ceases to be an Eligible Individual during this testing period. The IRS has issued IRS Notice , which provides additional clarification regarding the circumstances under which the Qualified HSA Distribution may be made tax free. Given the complexity of such distributions (and limited amounts involved) few employers allow participants to make Qualified HSA Distributions. Qualified HSA Funding Distribution (aka trustee-to-trustee transfer from IRA) The 2006 Act also permits a once-in-a-lifetime time tax free trustee-totrustee transfer of IRA funds to an HSA to the extent the transfer does not exceed the Annual Contribution Limit (determined in accordance with the 2006 Act, discussed in more detail below). The amounts transferred from the IRA to the HSA are included in income and subject to a 10 percent excise tax if the individual ceases to be an Eligible Individual (except for failure to maintain Eligible Individual status due to death or disability) during the Qualified HSA Funding Distribution testing period, which begins in the month in which the Qualified HSA Funding Distribution is made and ends on the last day of the 12th month following such month (e.g., if the Qualified HSA Distribution is made on July 1, 2007, the Qualified HSA Funding Distribution testing period ends July 31, 2008). Unlike Health FSA/HRA transfers, the IRA transfer is not treated as a rollover contribution. Thus, any amounts transferred from the IRA to the HSA during the year reduce the maximum amount (i.e., the Annual Contribution Limit) that may otherwise be contributed to the HSA during that year. Timing of Contributions Contributions for a particular year may be made at any time before the due date of the individual s tax return for that year (not including extensions). Consequently, contributions may be made monthly, semi-annually, or once at any time during the year (as early as the beginning of the year and as late as April 15 of the following year) or on any other schedule. Currently, 21

23 BANKING LAW JOURNAL conservative employers will only make contributions during the year due to W-2 reporting issues. In addition, as stated above, the employee may contribute with pre-tax contributions under his/her employer s cafeteria plan if the employer has amended the cafeteria plan to allow HSA pre-tax contributions. HSA trustee/custodians are required to report on the Form 5498-SA the total amount of contributions made during a year for the prior year (e.g., a contribution made on April 15, 2009 for the 2008 tax year); therefore, HSA trustee/custodians must ensure that it has a process for identifying these retro contributions (e.g., a form may require the contributor to indicate whether the contribution is for this year or the prior year). Contribution rules for self-employed individuals Generally, contributions made by or on behalf of self-employed individuals cannot be made on a tax-free basis; however they are deductible by the self-employed individual. Contributions made by or on behalf of selfemployed individuals are subject to the following rules: With regard to partners in a partnership, if contributions by a partnership to a partner s HSA are treated as distributions, then such contributions are NOT deductible by the partnership and do not affect the partner s distributive shares of partnership income and deductions. Moreover, the contributions are not included in the partner s net earnings from self-employment (for SECA purposes) if treated as distributions. With regard to partners in a partnership, if contributions by a partnership to a partner s HSA are treated as guaranteed payments, then such contributions are deductible by the partnership (thus they affect the partner s distributive shares of partnership income and deductions). Moreover, the contributions are included in the partner s net earnings from self-employment (for SECA purposes) if treated as guaranteed payments. With regard to more-than-two percent shareholders in an S-corporation, contributions by the S-corporation to a more-than-two percent shareholder s HSA are treated as guaranteed payments and are deductible by the corporation and included in the more-than-two percent sharehold- 22

24 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL er s income. Generally, such contributions are subject to FICA (as opposed to SECA) except in certain limited situations. 40 Contribution Limits General Overview As noted above, HSA contributions can be made by virtually anybody on behalf of the Eligible Individual, so long as all contributions for the calendar year, in the aggregate, do not exceed the Account Beneficiary s Annual Contribution Limit. The Annual Contribution Limit is equal to the sum of all monthly limits for the taxable year, excluding rollover contributions, and taking the Last-Month Rule (described below) into account. The monthly limit for any month is 1/12th of the Statutory Maximum Annual Contribution for the applicable level of coverage (the Pro Rata Rule ). The amount of the Statutory Maximum Annual Contribution is subject to annual COLAs. The 2008 Statutory Maximum Annual Contribution amount for single coverage is $2,900 and the 2008 Statutory Maximum Annual Contribution amount for family coverage is $5, Planning Pointer: As noted above, the 2006 Act changed the Annual Contribution Limit beginning January 1, Prior to the 2006 Act, the Annual Contribution Limit amount was the sum of the monthly limits based on the lesser of the deductible or the applicable Statutory Maximum Annual Contribution amount. The 2006 Act eliminated the lesser of the deductible rule so that the Annual Contribution Amount is based only on the Statutory Maximum Annual Contribution for the applicable level of coverage. Consider the following example to illustrate this rule: Bob enrolls in single HDHP coverage on January 1, Bob is covered through June 30,

25 BANKING LAW JOURNAL Number of Months Bob was an Eligible Individual During Bob s monthly limit for 2008 $ ($2900/12) Bob s Statutory Maximum Annual Contribution Amount for 2008 $1450 (6 x $241.66) The Account Contribution Limit amount is increased for Account Beneficiaries who will attain age 55 by the end of the taxable year ( Catch- Up Contribution ). Unlike most of the other limits, the Catch-Up Contribution is not subject to COLAs; however, it does increase each year. The Catch-Up Contribution is $900 (for 2008), and increases by $100 each year, up to $1,000 for taxable years beginning in 2009 and thereafter. The individual is entitled to the pro-rata portion of the additional contribution amount for the months that he or she is an Eligible Individual so long as the individual turns age 55 before the end of the tax year, without regard to whether he or she has turned age 55 at the time he or she ceases to be an Eligible Individual. If an Account Beneficiary contributes more than his/her Annual Contribution Limit, he/she will have an excess contribution (see below for a more detailed discussion on excess contributions). Last Month Rule Exception to Pro Rata Rule Under the 2006 Act, an individual who first becomes an Eligible Individual anytime on or before the first day of December of any year is treated as though he/she is an Eligible Individual for each month during that year (the Last Month Rule ) so long as he/she continues to be an Eligible Individual during the Last Month Rule testing period. Under the Last Month Rule, the individual is treated for months that the individual is deemed to be an Eligible Individual solely as a result of the Last Month Rule as having the same level of coverage in effect in December of that year. The Last Month Rule testing period begins in December of the year in which the individual became an Eligible Individual and ends on the last day of the 12th month following such month. If the individual ceases to be an 24

26 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Eligible Individual during the Last Month Rule testing period, all contributions attributable to months for which the individual was treated as an Eligible Individual during the year solely as a result of Last Month Rule are included in gross income for the year in which the individual ceases to be an Eligible Individual (other than disability or death) and such amounts are subject to a 10 percent excise tax. Consider the following example to illustrate this rule: Bob enrolls in single HDHP coverage on July 1, Bob is covered through the end of the year. Bob may contribute the full Statutory Maximum Annual Contribution amount (determined in accordance with the 2006 Act s new contribution limit provisions). Thus, Bob may contribute $2,900 for 2008, even though he was only an Eligible Individual for seven months. Bob terminates employment on February 1, 2009 and consequently loses coverage under the HDHP. All contribution amounts attributable to January 1, 2008, through June 30, 2008 ($1,450 or 1/2 of $2,900) will be included in Bob s income in 2008 and subject to a 10 percent excise tax. Planning Pointer: The amounts included in income under the Last Month Rule are not treated as excess contributions. Consequently, the Account Beneficiary cannot withdraw the amounts that are included in income pursuant to the Last Month Rule prior to the due date of his/her tax return to avoid the excise tax as the Account Beneficiary can with an excess contribution. See below for a detailed discussion regarding excess contributions Trustee/Custodian Responsibility for Monitoring the Contribution Limit Ultimately, the Account Beneficiary is responsible for monitoring the amounts contributed to his/her HSA. The trustee is not required to verify coverage, eligibility, or the Annual Contribution Limit; however, the trustee/custodian is required to ensure that no more than the Statutory 25

27 BANKING LAW JOURNAL Maximum Annual Contribution amount for family coverage (for 2008, $5,800), including any Catch-Up Contributions for those age 55 or older, is received and allocated to the individual s HSA account (without regard to the level of coverage the individual may actually have). 42 Thus, the trustee must also track the individual s age; however, the trustee/custodian may rely on the Eligible Individual s certification regarding his/her age. 43 This rule is illustrated in the following example: Bob, who is under age 55, establishes an HSA with ABC HSA, Inc. Bob is an Eligible Individual with single coverage throughout 2008; therefore, his Annual Contribution Limit is $2,900. Bob wishes to make a contribution of $5,700. ABC HSA has no obligation to reject that contribution even though it exceeds his Annual Contribution Limit. However, if Bob wishes to make a contribution of $5,801 or greater, it would be ABC HSA s responsibility to reject any amounts over $5,800. Employer Responsibility for Monitoring the Contribution Limit The employer s contributions are excluded from income and employment tax withholding liability, even if such contributions are later determined to be included in the employee s gross income, so long as the employer has reason to believe that the contributions will be excluded from income when the employer makes them. 44 Thus, if the employer makes contributions that it knows or should know will not be excluded from income (e.g., the employer makes a full year contribution in January for an employee it knows is retiring in March), the employer will be liable for income and employment tax withholding on those amounts. Moreover, the employer is also responsible for tracking the individual s age, presumably so that the employer can monitor the contributions for those eligible for the Catch-Up Contribution. 45 Special Contribution Rules for Married Couples Although an employee and spouse cannot have combined HSAs, there is a special rule for determining the amount that each spouse who is an Eligible Individual may contribute to his or her HSA. For married individuals, if 26

28 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL either spouse has family coverage, then the aggregate Annual Contribution Limit for both spouses is the Statutory Maximum Annual Contribution amount for family coverage ($5,800 for 2008). The aggregate Statutory Maximum Annual Contribution amount is divided equally between the spouses or as they otherwise agree. This rule is illustrated in the following example: Betty has single coverage under her employer s HDHP. Betty s spouse, Ken, has family coverage under his employer s HDHP. In this example, the most that Ken and Betty can contribute to their HSAs, in the aggregate, is the Statutory Maximum Annual Contribution amount ($5,800 for 2008). Generally, they have full discretion regarding the manner in which that $5,800 is allocated to each spouse s HSA. Excess Contributions Any amount that exceeds the Annual Contribution Limit is called an excess contribution. Excess contributions are subject to a six percent excise tax unless the excess contributions (and any net earnings attributable to the excess contributions) are returned to the Account Beneficiary before the last day of the period for filing the individual s tax return (including any extensions). 46 Consider the following example to illustrate this rule: Bob s employer contributes $2,900 to Bob s HSA on January 1, Bob terminates employment on March 15, Bob has an excess contribution of $2, (10/12ths of $2900). Bob must withdraw the $2, and any earnings on such amounts prior to April 15, 2009 (or the extended due date if applicable) in order to avoid the six percent excise tax. In addition, the $2, and the earnings will be included in Bob s gross income when he files his tax return. NOTE: If the employer had no reason to believe that Bob would terminate employment when the employer contributions were made on January 1, 2008, then employer would have no income or employment tax withholding liability on the $2, excess contribution. In addition, the employer would have no 27

29 BANKING LAW JOURNAL obligation to show that amount as included in gross income on Bob s W-2 (i.e., it would be up to the Bob to properly report that as income on his tax return for 2008). Calculating Earnings on Excess Contributions Earnings on excess contributions are calculated in the same way that earnings on excess IRA contributions are calculated. 47 Planning Pointer: It is interesting to note that regulations that provide the basis for calculating earnings on excess contributions do not specifically require the custodian/trustee to calculate that amount. 48 The instructions to the Form 1099-SA merely indicate that the custodian/trustee is required to report the earnings amount but does not affirmatively impose on the custodian/trustee the obligation to calculate the earnings amount. Notwithstanding the lack of affirmative guidance, conservative custodians/trustees will actually calculate the earnings amount for the Account Beneficiary. Employer Contributions Employers may make an excludable contribution to the HSA subject to the above limits and a non-discrimination requirement (the Comparability Rule ) which may apply. Such contributions are exempt from FICA and FUTA taxation, as noted above, to the extent the employer had reason to believe that the contribution would be excludable from income when they were made. On July 31, 2006, the IRS issued final regulations concerning the Comparability Rule under Code Section 4980G, which imposes a 35 percent excise tax on employers who fail to make comparable contributions to its comparable participating employees HSAs. The Comparability Rule set forth in Code Section 4980G imposes a 35 percent excise tax on the aggregate total of an employer s HSA contributions unless the employer makes available comparable contributions to the [HSAs] of all comparable participat- 28

30 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL ing employees for each coverage period during such calendar year (emphasis added). 49 What are Comparable Participating Employees? Comparable participating employees have at least the following three things in common: 1) they are Eligible Individuals (as defined in Code Section 223(c)(1), 2) they are in the same employment category, and 3) they have the same level of coverage. The regulations clarify that there are three separate employment categories under the Comparability Rule: Full-time employees; Part-time employees (i.e., employees who are customarily employed for fewer than 30 or more hours per week); and Former employees. Note: a special rule applies that allows employers to exclude former employees receiving coverage under the employer s HDHP as a result of a COBRA election. 50 There are, however, a couple of exceptions: Union employees are not subject to Comparability Rule. 51 The 2006 Act permits employers to contribute more to the HSAs of non-highly compensated employees ( non-hces ) than it contributes to highly compensated employees ( HCEs ) who are comparable participating employees. However, the employer must still satisfy the Comparability Rule (i.e., if employer contributions to the HSA of a fulltime non-hce, the employer must make comparable contributions to the HSAs of all full-time non-hces). Planning Pointer: As noted above, only employees who are Eligible Individuals as defined in Code Section 223(c)(1) must be considered for purposes of the Comparability Rule. Thus, a current full-time employee 29

31 BANKING LAW JOURNAL who does not have qualifying HDHP coverage sponsored by the employer but is covered under his/her spouse s employer s HDHP is an Eligible Individual (assuming all other eligibility requirements are satisfied). However, as noted in more detail below the employer is able to restrict contributions to those employees who participate in the employer s HDHP. 52 Employers may treat employees with different levels of coverage separately for purposes of the Comparability Rule. If an employer makes HSA contributions for an employee within a specified employment category and with a particular category of coverage, the employer must make comparable contributions to all employees in the same employment category who have the same category of coverage. However, an employer is not required to make HSA contributions for employees with one level of coverage (e.g., family) solely because the employer makes HSA contributions for employees in the same employment category with a different level of coverage (e.g., self-only). Thus, contributions can vary between coverage categories. Planning Pointer: Many employers have multiple categories of family coverage (e.g., employee, employee plus spouse, employee plus kids, family). The final Comparability Rule regulations identify three different categories of family coverage: employee plus one, employee plus two, and employee plus three. The employer does not violate the Comparability Rule if it makes different contributions for each level of family coverage so long as the contribution for employee-plus-two is equal to or greater than employee-plusone and the contribution for those with employee-plus-three is equal to or greater than employee-plus-two. 53 The IRS did not provide guidance in the final regulations regarding employees who fail to establish an HSA by the end of the year. However, the proposed regulations recently issued by the IRS indicate that an employer does not violate the Comparability Rules for failing to make an HSA con- 30

32 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL tribution on behalf of an otherwise eligible employee because the employee did not establish an HSA or the employer did not know that the employee established an HSA if both of the following conditions are satisfied: The employer provides written notice to all Eligible Employees that it will make the required HSA contributions under the Comparability Rule if the employee both establishes an HSA and notifies the employer that he/she have established an HSA by no later than February 15 of the following year. [Prop. Treas. Reg G-4, Q-14(a)(1)]. The notice is considered timely if the employer provides notice no earlier than 90 days before the first HSA contribution for that calendar year and no later than January 15 of the following calendar year. For every employee who provides timely notice to the employer, the employer makes the comparable contribution to the HSA, plus reasonable interest, no later than April 15 following such calendar year. [Prop. Treas. Reg G-4, Q-14(a)(2)]. The notice may be provided electronically in accordance with the electronic communication regulations set forth in Treas. Reg (a)-21. What are Comparable Contributions? An employer who makes HSA contributions for its employees must make comparable contributions. The statute provides that comparable contributions are a) the same amount or b) the same percentage of the deductible for each comparable participating employee. Although simple on its face, application of the rule can be complicated based upon the timing of when contributions are made (e.g., in advance, in arrears, or pay-as-you-go ), especially with respect to part-year employees. The Comparability Rule does not require an employer to make any HSA contribution at all. The Comparability Rule only applies if the employer makes otherwise excludable HSA contributions. For purposes of the Comparability Rule, employer contributions made through a cafeteria plan (discussed below) are not considered. Also, after-tax contributions made by an employer are not subject to the Comparability Rule. Thus, for example, 31

33 BANKING LAW JOURNAL if an employee requests that his or her employer deduct after-tax amounts from the employee s compensation and forward them to the employee s HSA, then these contributions are not subject to the Comparability Rules of Code 4980G, because an employee s after-tax contributions to an HSA do not constitute employer contributions under Code 106(d). 54 If an employer makes HSA contributions for one category of comparable participating employees, then the employer is not required to make comparable contributions for another category of comparable participating employees. Thus, for example, if an employer makes HSA contributions for current full-time employees with self-only coverage, the employer is not required to make comparable HSA contributions for current full-time employees with family coverage. The testing period under the Comparability Rule is the calendar year. 55 However, contributions are deemed comparable if they are comparable when determined on a month-to-month basis. 56 To accommodate contributions for part-year employees, contributions can be made on a pay-as-you-go, look-back, or pre-fund basis. As described in the Comparability Rule regulations, different requirements apply to each of these contribution methods. Cafeteria Plan Exception to Comparability Requirement The final regulations confirm that the Comparability Rules do not apply to employer contributions made through a cafeteria plan. 57 Thus, for example, when matching contributions are made through a cafeteria plan (e.g., providing a contribution to the HSA of each eligible employee in an amount equal to the employee s pre-tax HSA contribution or a percentage of it), the matching contributions are not subject to the Comparability Rule. 58 But when exactly are HSA contributions other than matching contributions and pre-tax salary reductions made through a cafeteria plan? The final regulations clarify an employer s contributions to an employee s HSA is made through the cafeteria plan if the employee for whom the contribution is made was provided an opportunity to make additional HSA contributions through the cafeteria plan in the form of pre-tax salary reductions, without regard to whether the employee elected pre-tax salary reductions or not. The follow example illustrates this rule: 32

34 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Employer sponsors an HDHP and makes $500 contribution to any HDHP participant who establishes an HSA. Employer also sponsors a Code Section 125 Cafeteria Plan through which eligible employees may contribute to an HSA with pre-tax salary reductions. Bob and Joe are HDHP participants and both establish an HSA. Bob and Joe are both eligible for the cafeteria plan but only Bob elects to contribute to his HSA with pre-tax salary reductions. Employer s contributions to Bob s and Joe s HSA are made through the cafeteria plan because both were provided the opportunity to make additional contributions through the cafeteria plan with pre-tax salary reductions. It is irrelevant that Joe did not elect pre-tax salary reductions. Corrections As noted above, an employer who fails to comply with the Comparability Rule is subject to a 35 percent excise tax on all HSA contributions made by the employer during the calendar year (including those contributions that would have otherwise complied with the Rule). As a result, employers that inadvertently run afoul of the Comparability Rule may need to take corrective action to avoid application of the excise tax. The final regulations clarify that employers cannot recoup any non-comparable contributions because an employee s interest in an HSA is non-forfeitable. 59 An employer may, however, cure a violation of the Comparability Rule by making additional contributions (up to an employee s Annual Contribution Limits) on or before April 15th of the year following the calendar year in which the violation occurred. 60 Also, IRS has the authority to waive the excise tax in the case of a failure that is due to reasonable cause and not willful neglect to the extent that the tax would be excessive with regard to the failure involved. 61 Distributions Distributions from the HSA are excluded from income to the extent that they are for qualified medical expenses incurred after the establishment of the HSA. 62 A qualified medical expense is generally an amount for medical 33

35 BANKING LAW JOURNAL care, as defined in Code 213(d), for the Account Beneficiary, the Account Beneficiary s legal spouse (in accordance with state law but consistent with the federal Defense of Marriage Act), or the Account Beneficiary s tax dependents (as defined under Code Section 223) to the extent such amounts are not reimbursed by insurance or otherwise. 63 With certain exceptions, qualified medical expenses do not include payments for health insurance premiums. 64 Therefore, neither the Account Beneficiary nor his or her spouse or dependent can generally pay for HDHP coverage or other health coverage from the HSA. The following are considered to be qualified medical expenses notwithstanding the general proscription on insurance premiums: COBRA coverage; A qualified long-term care insurance contract subject to Code Section 213 deduction limits for long term care insurance premiums; Any health plan maintained while the individual is receiving unemployment compensation under federal or state law; or For those age 65 or over (i.e., those eligible for Medicare), any health insurance, including Medicare premiums, other than a Medicare supplemental policy. 65 Neither the HSA custodian/trustee nor a contributing employer is required to determine whether HSA distributions are used for qualified medical expenses. In addition, neither the HSA custodian/trustee nor the contributing employer is allowed to require substantiation as a condition precedent to distribution from the HSA. 66 Thus, unlike HRAs and Health FSAs, third party adjudication is not permitted to be a requirement for HSA distributions. That being said, at least one bill has been proposed by Congress that would require HSA trustee/custodians to report the total number of unsubstantiated distributions during a year; distributions could still be taken for any reason but HSA trustees/custodians would have to ask for substantiation in conjunction with all distributions. 67 HSA distributions are self-adjudicated and reported as taxable or not by the HSA Account Beneficiary. Recent IRS guidance allows for the re-deposit 34

36 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL of certain mistaken distributions if there is clear and convincing evidence of a mistake due to reasonable cause. 68 However, the trustee/custodian is not required to accept mistaken distributions. 69 The guidance also confirms that distributions may be deferred until many years after a claim is incurred (i.e., a shoebox rule) as long as adequate records are maintained. 70 Furthermore, expenses must be incurred after the HSA is established in order to be a qualified medical expense and only distributions equal to the account balance may be distributed. However, an employer may make accelerated contributions to the employee s HSA up to the employee s annual HSA election to facilitate distributions in excess of the account balance so long as the employer makes accelerated contributions equally available to all participants and the employee repays the employer. 71 Planning Pointer: Nothing in the HSA rules prohibits the use of a debit card to access HSA funds. Unlike a debit card used in conjunction with a Health FSA or HRA, the debit card used in conjunction with an HSA would not be subject to the strict substantiation requirements applicable to health plans. See Rev. Rul and Notice (including the requirement in those rulings to limit use of the card to certain merchants). Taxable Distributions Unlike other health arrangements (e.g., FSAs and HRAs), amounts in an HSA can be withdrawn on a taxable basis even though no medical expense has been incurred. If a distribution is made from the HSA for other than a qualified medical expense, the distribution is included in the Account Beneficiary s taxable income and is generally subject to an additional 10 percent tax. 72 The 10 percent additional tax does not apply to any distributions from the HSA that are made in the following instances (however regular income tax does still apply): Payments made following the HSA Account Beneficiary s death. 35

37 BANKING LAW JOURNAL Payments made after the HSA Account Beneficiary becomes eligible for Medicare. This gives Medicare Eligible Individuals the option to use accrued HSA funds for medical expenses on a tax-free basis or to receive the funds in cash without the additional 10 percent tax. Payments made after the Account Beneficiary becomes disabled as defined in Code 72. The return of excess contributions to the extent returned prior to the individual s tax return due date in accordance with the statute s requirements. 73 Such amounts are also not included in income if attributable to after-tax contributions. Amounts distributed from an HSA that are contributed to another HSA within 60 days after the distribution is received. This rollover contribution is limited to one every 12 months. Such amounts are also not included in income. Transfer of HSA Upon Death or Divorce An Account Beneficiary s interest in an HSA can be transferred under a divorce or separation instrument to an HSA established for the spouse (or exspouse). In the event of such a transfer the distribution is not subject to taxation or the excise tax, and the spouse (or ex-spouse) becomes the Account Beneficiary of the HSA. Upon the death of an HSA Account Beneficiary any amounts remaining in the HSA are transferred to the beneficiary of the HSA named in the HSA instrument. If the beneficiary is the Account Beneficiary s spouse, the spouse becomes the Account Beneficiary of the HSA and the transfer is not subject to taxation. If the interest is transferred to someone other than the beneficiary s spouse upon death, the account ceases to be an HSA and an amount equal to the fair market value of the account assets as of the date of the beneficiary s death is taxable income. Unless the transferee is the decedent s estate, the includable amount is reduced by any payments from the HSA made for the decedent s qualified medical expenses, if paid within one year after death. Whether the amount is subject to income or estate tax depends upon whether the interest is transferred to the beneficiary s estate. 36

38 ERISA HAPPENS (OR HOW TO AVOID IT) HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL In addition to the tax issues discussed above, HSAs may, under some circumstances be subject to ERISA s requirements. ERISA will always apply to the HDHP of a private employer. However, ERISA will not necessarily apply to the HSA and can be avoided if the HSA is properly structured. Financial institutions have a keen interest in ensuring that the employer structures its HSA arrangement to avoid ERISA because ERISA application could bring with it potential compliance baggage under HIPAA and COBRA as well. Planning Pointer: Both the ERISA and the Code contain parallel prohibited transaction provisions. Even if ERISA does not apply, the prohibited transactions under the Code still apply. See Prohibited Transactions (discussed below) for more information regarding prohibited transactions and HSAs. Initially, it was not clear whether HSAs would be subject to ERISA. ERISA application would create a substantial administrative burden for employers and custodian/trustees. Not only would ERISA required annual reports (Form 5500s) be required, but also financial schedules and an auditor s report may be required. Instead of a simple communication packet, employers would be required to prepare summary plan descriptions ( SPDs ) that comply with ERISA s comprehensive disclosure requirements. Fortunately, in April 2004, the Department of Labor s Employee Benefits Security Administration ( EBSA ) issued guidance in the form of field assistance bulletin ( FAB ) , which details when HSAs would be subject to ERISA. The EBSA followed up its guidance with FAB FABs are discussed in more detail below. General Overview Initially, there was concern that employer contributions to the HSA would cause ERISA to apply to the HSA. However, the DOL has conclud- 37

39 BANKING LAW JOURNAL ed that employer contributions to an HSA do not automatically result in ERISA applicability. The employer can rely on a special safe harbor set forth in FAB that permits employer contributions to an HSA outside of the ERISA framework provided that certain other requirements are satisfied. Special HSA Safe Harbor The DOL indicates that it would not find that employer contributions to an HSA give rise to ERISA applicability so long as all of the following conditions are satisfied: (1) Establishment of the HSA must be completely voluntary. FAB does not define voluntary for purposes of determining ERISA applicability to HSAs; however, the DOL clarified in FAB that the intent of the voluntary requirement in FAB is to ensure that employee contributions to an HSA, including salary reductions, are voluntary. 74 Thus, an HSA is still completely voluntary (an essential element of the FAB safe harbor ERISA exception) even if the employer unilaterally establishes an HSA for employees and subsequently deposits employer funds in the HSA. 75 (2) The employer does not limit the ability of the employee to move funds to another HSA beyond that permitted by the Code. This rule appeared to permit employers to limit the forwarding of contributions through its payroll system to a single HSA provider so long as the employees could still move the funds to another HSA provider. The DOL clarified in FAB that making contributions to a single HSA custodian does not by itself trigger ERISA under the special HSA safe harbor. 76 HSA trustee/custodians should be wary of imposing an exorbitant fee to transfer funds to another HSA trustee/custodian. An exorbitant fee might be construed as prohibitive in nature and inadvertently trigger ERISA. (3) The employer does not impose conditions on the utilization of HSA funds beyond that permitted by the Code. Under the Code, HSA funds may be distributed to the HSA Account Holder for any reason non-medical distributions are subject to income tax and an excise tax. Recent IRS 38

40 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL guidance confirms that distributions cannot be restricted to medical expenses. (4) The employer does not make or influence investment decisions with respect to funds contributed to the HSA. Presumably, limiting contributions through the payroll system to a single HSA provider that invests in a single deposit vehicle or limited set of funds would not (in and of itself) result in ERISA applicability. Remember, the employee is free to move funds to another HSA. FAB clarified that an employer does not invoke ERISA solely by choosing an HSA vendor that offers the same investments offered under its 401(k) plan as long as employees are afforded a reasonable choice of investments and are not limited in moving funds to another HSA. 77 Note, however, that a single investment option is not considered to be a reasonable choice of investments. 78 Does this mean that a single certificate of deposit or interest bearing deposit account option, which is standard in the industry (at least until the account balance exceeds a threshold amount) is problematic by itself? Most bank trustee/custodians are hoping the answer is no. One interpretation is that the guidance is referring to situations where the investments under the HSA mirror the investments under the 401(k) and not merely deposit products. Additional guidance is needed from the DOL on this issue. Regardless, HSA trustees/custodians should be cautious not to give way to client requests to change investment options offered as part of the HSA trustee/custodian s standard portfolio except as otherwise necessary to match the employer s 401(k) portfolio. (5) The employer does not represent that the HSAs are established or maintained by the employer. Plan sponsors should have legal counsel review communications to participants to ensure that communication materials regarding the HSA do not imply that the HSA is an ERISA plan or part of the employer s other ERISA plans. The DOL noted in FAB that endorsement, which is an issue under the group insurance arrangement safe harbor, does not apply under the HSA safe harbor under Planning Pointer: Although endorsement is not an element of the special HSA safe harbor, employers will still 39

41 BANKING LAW JOURNAL need to exercise caution in how they communicate the HSA to employees; ensuring that employees understand that the HSA is not an employer-sponsored plan despite the fact that the employer has chosen the particular custodian to which it will make contributions. A carefully drafted disclaimer would seem to be essential in this regard. (6) The employer does not receive any payment or compensation in connection with the HSA. The DOL clarified in FAB that an employer s FICA and FUTA tax savings through a cafeteria plan are not payment or compensation that would trigger ERISA under This seems to confirm that merely including an HSA contribution as an option in a cafeteria plan will not cause the HSA itself to be subject to ERISA. Planning Pointer: BEWARE WHEN PACKAGING DISCOUNTS. HSA vendors have been extremely innovative in packaging HSA products and services with other benefit plan services (health benefit card administration fees, FSA administration, etc.). If the HSA relationship results in a discounted fee (e.g., for health benefit card administration and processing) the employer may be deemed to have received compensation in connection with the HSA, which triggers ERISA under FAB and Moreover, the employer and vendor may have engaged in a prohibited transaction. 80 For example, it would appear that an arrangement where the HSA product is combined with other products offered by the HSA vendor (e.g., other administrative services or HDHP coverage) and the vendor charges a lower fee for such products to the employer as a result of the HSA relationship (than where the product is offered on a stand-alone basis) ERISA coverage of the HSA would apply. Such receipt of compensation (i.e., the discounted fee) by the employer may also be in violation of the tax and ERISA prohibited transaction rules. 40

42 Employer Payment of HSA Fees HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL The DOL indicated in FAB that employers can pay the employees HSA fees without triggering ERISA. This conclusion allays the fears of many employers that have chosen to foot the bill for HSA administrative costs. 81 Can a Bank Custodian/trustee Offer Its Own Product to Its Employees? The DOL further indicated in FAB that HSA vendors may offer their own employees the same HSA product that they offer to the general public without triggering ERISA. 82 Although good news generally, additional detail is still needed from the DOL. For example, prior IRA-related guidance from the DOL indicates that ERISA does not apply where IRA custodians charge their own employees the market fee. Although not directly applicable to HSAs, it raises the question as to whether employers may charge their own employees a fee. Informal guidance from DOL officials indicates that a market fee may be charged to employees who establish HSAs with the employer/hsa custodian without triggering ERISA. Also, since employers generally can pay HSA fees, a discounted fee for employees should be permissible as well. PROHIBITED TRANSACTION ISSUES Code Section 223(e)(2) indicates that rules similar to the IRA rules for prohibited transactions and pledging the HSA as security for a loan shall apply to HSAs and any amount treated as distributed under such rules shall be treated as not used to pay qualified medical expenses. Thus, these two events will trigger significant adverse tax consequences to any HSA Account Holder and should be avoided. General Overview Code Section 408(e)(2) indicates that the account ceases to be an IRA as of the first day of the year in which an individual or his beneficiary 41

43 BANKING LAW JOURNAL engages in a prohibited transaction as set forth in Code Section Likewise, the HSA ceases to be an HSA as of the first day of the year in which the Account Beneficiary engages in a prohibited transaction (by virtue of the reference to Code Section 408(e)(2)). As a result, the fair market value of the HSA account as of the first day of such year is deemed to be distributed to the Account Beneficiary. 84 Code Section 223 clarifies that any such distribution is not deemed to be used for qualified medical expenses. 85 Consequently, any such amounts deemed distributed are included in the Account Beneficiary s income and subject to the additional 10 percent excise tax (if applicable). 86 In addition, any contributions made to the account after the first day of the year in which such HSA is terminated by virtue of the prohibited transaction are not treated as made to an HSA and as a result, are not subject to the tax advantages (discussed above) provided by a Code Section 223 HSA. Thus, employer contributions to the HSA and earnings on such contributions would be included in income, and after-tax contributions made to the account after such date would not deductible. IRS Notice indicates that the rules that apply to account beneficiaries apply to custodian/trustees as well. 87 It is important to note that there are parallel prohibited transaction rules set forth in ERISA; however, it is clear that the prohibited transaction provisions in the Code apply even if ERISA is not applicable. 88 That being said, the DOL has been given authority to regulate prohibited transactions, even where the arrangement is not subject to ERISA. By the Book: Prohibited Transaction Provisions A prohibited transaction means any direct or indirect: (1) Sale or exchange, or leasing, of any property between a plan and a disqualified person, whether or not the property is owned by the plan or a disqualified person; (2) Lending of money or other extension of credit between a plan and a disqualified person; (3) Furnishing of goods, services, or facilities between a plan and a disqual- 42

44 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL ified person; (3) Transfer to, or use by or for the benefit of, a disqualified person of the income or assets of a plan ; (4) Act by a disqualified person who is also a fiduciary and who deals with the income or assets of a plan in his own interest or for his own account; or (5) Receipt by a disqualified person who is a fiduciary of consideration for his own personal account from any party dealing with the plan in connection with a transaction involving the income or assets of the plan. 89 (6) Under ERISA, acting by a fiduciary on behalf of someone whose interests are adverse to the Account Beneficiary. 90 The plan for purposes of the prohibited transaction rules is the HSA. 91 In order to be a prohibited transaction, the transaction must involve a Disqualified Person. A Disqualified Person means anyone who meets any of the following conditions: (1) A fiduciary (which means anyone who has discretionary authority over management or administration of the plan or who is an investment advisor, including the Account Beneficiary); (2) A person providing services to a plan (such as an HSA administrator or even a custodian); (3) An employer any of whose employees are covered by the plan; (4) An employee organization (labor union, etc.) any of whose members are covered by the plan; (5) An owner, direct or indirect, of 50 percent or more of the combined voting power of all classes of stock entitled to vote or the total value of shares of all classes of stock of a corporation that is an employer or employee organization described in (3) or (4), above; (6) An owner, direct or indirect, of 50 percent or more of the capital interest or the profits interest of a partnership that is an employer or employee organization described in (3) or (4), above; 43

45 BANKING LAW JOURNAL (7) An owner, direct or indirect, of 50 percent or more of the beneficial interest of a trust or unincorporated enterprise that is an employer or employee organization described in (3) or (4), above; (8) A member of the family (spouse, ancestor, lineal descendant, and any spouse of a lineal descendant) of an individual described in (1) (3) and (5) (7) above; (9) A corporation in which 50 percent or more of the combined voting power of all classes of stock entitled to vote, or of the total value of shares of all classes of stock, is owned directly or indirectly or held by persons described in (1) (7) above. Prohibited Transaction Exemptions The prohibited transaction rules create a blanket prohibition against certain transactions, regardless of how innocent or prudent the transaction may seem (The IRS has stated that Good intentions and a pure heart are no defense. ). 92 However, Congress created the following statutory exemptions for what would otherwise constitute prohibited transactions: (1) Lease or contract for services or office space to the extent that (i) such office space or service is necessary for the establishment or operation of the HSA; (ii) such office space or service is furnished under a contract or arrangement which is reasonable; and (iii) no more than reasonable compensation is paid for such office space or service. 93 Whether compensation is reasonable depends on the applicable facts and circumstances. 94 A service is necessary for the establishment or operation of a plan within the meaning of Code Section 4975(d)(2) if the service is appropriate and helpful to the plan obtaining the service in carrying out the purposes for which the plan is established or maintained. No contract or arrangement is reasonable within the meaning of Code Section 4975(d)(2) if it does not permit termination by the plan without penalty to the plan. Planning Pointer: Although often overlooked, all service agreements between the HSA (or on behalf of the HSA) and 44

46 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL an HSA service provider constitute a prohibited transaction under Code Section 4975; however, such arrangements are exempted to the extent that a fiduciary (e.g., the HSA Account Beneficiary) determines that the compensation paid to the service provider is reasonable and the services are necessary. (2) If a bank is a trustee or other fiduciary for the plan, plan assets may be deposited in the bank, provided that the interest rate is reasonable and the deposit is authorized by the terms of the HSA or by a fiduciary unrelated to the bank that is expressly given this power by the HSA Account Beneficiary. 95 (3) An HSA may purchase an interest in a common trust or pooled investment fund maintained by a bank or trust company that is a disqualified person if the HSA expressly authorizes the investment and various other conditions are met. 96 (4) An HSA may utilize an ancillary service (e.g., checking services) of a bank serving as fiduciary for the plan if compensation for the service is reasonable and the bank adopts safeguards to prevent use of the service that is excessive, unreasonable, or inconsistent with the best interests of participants and beneficiaries (e.g., accumulation in interest-free checking accounts of funds that should be invested elsewhere). 97 (5) An HSA may exercise a conversion privilege under securities issued by a disqualified person (e.g., the trustee) if it receives adequate consideration in the conversion. 98 In addition, the DOL may issue individual and/or class exemptions to transactions that are otherwise prohibited transactions under certain circumstances. Application of Prohibited Transaction Rules to HSAs It is not entirely clear how the prohibited transaction rules apply to HSAs. Many of the specified acts and the exemptions do not fit neatly with 45

47 BANKING LAW JOURNAL HSAs. There is a vast multitude of guidance on IRAs; however, DOL has indicated that the IRA guidance does not apply to HSAs despite their similarities. 99 The DOL has issued limited guidance regarding the application of prohibited transactions to HSAs. First, in Advisory Opinion A, the DOL addressed two factual scenarios that help put the prohibited transaction rules as they relate to HSAs into perspective. Under the first factual scenario, an insurance company both insured the HDHP and was the custodian/trustee of the HSA. To encourage participation in the company s HSA program, the company offered an incentive to a person who established an HSA with the company when he or she first entered into an individual HDHP with the company. The incentive was in the form of a $100 cash credit by the company, as custodian/trustee, directly to the individual s HSA. The credit to the HSA was automatic and was not conditioned on the account beneficiary making contributions to the HSA. The credit was dependent solely on the establishment of an HSA with the company. In second fact scenario, the company entered into a contractual relationship with a specified bank to provide HSAs for individuals covered by group HDHPs issued by the company. However, an individual did not have to establish an HSA with the bank to participate in a group HDHP issued by the company. The bank served as the trustee or custodian and the recordkeeper of those HSAs and received remuneration from the company for its services in that regard. The company also enters into a contractual relationship with a specified entity (the vendor) to provide various services in relation to the HSAs, for which the company compensated the vendor. To encourage the establishment of HSAs with the bank in connection with group HDHPs issued by the company, the bank will offer an incentive to a person who established an HSA with the bank when the company first covered such person under a group HDHP. The incentive was also in the form of a $100 cash credit from the bank directly to the individual s HSA. The credit to the HSA was automatic and was not conditioned on the account beneficiary making contributions to the HSA. The credit was dependent solely on the establishment of an HSA with the company. 46

48 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL The DOL held the following in Advisory Opinion A: In both scenarios, the account holder was held to be a fiduciary and thus a disqualified person with respect to the HSA. Under Factual Scenario I, the company was a disqualified person with respect to the HSA since it was a trustee/custodian of the HSA. Under Factual Scenario II, the bank was a disqualified person with respect to the HSA since it was a custodian/trustee. However, the company was not a disqualified person with respect to the HSA in factual scenario II. Under both Factual Scenarios, the $100 credit was a cash contribution to the account holder s HSA. It was held that a cash contribution to an HSA is not generally a sale or exchange of property, transfer of plan assets or an act of self-dealing by either the company or the bank under Code Section 4975; however, the conclusion would have apparently been different had the account beneficiary received the cash contribution directly. Planning Pointer: Offers of inducement to enroll in an HSA or use HSA assets in a particular way are problematic. 100 Account Beneficiaries and HSA vendors should be cautious of such arrangements. Prohibited Transaction Traps The DOL s holdings in Adv. Op A are very helpful in understanding how the prohibited transaction rules will generally apply to HSAs (e.g., custodian/trustees will be disqualified persons, as will account beneficiaries) and how they operate in this particular fact pattern. The following is an overview of some other situations in which a prohibited transaction might occur: An HSA custodian or trustee s receipt of compensation from a third party directly or indirectly related to the services provided to the HSA, such as mutual fund 12b-1 fees and interchange fees if a debit card is 47

49 BANKING LAW JOURNAL used in conjunction with an HSA, without disclosing such fees to the Account Beneficiary. An HSA custodian or trustee s failure to promptly forward participant s HSA contributions to the trust. 101 An HSA custodian or trustee s establishment of intentional overdrafts or lines of credit associated with an HSA. The DOL has previously ruled that a traditional overdraft resulting solely from the payment process that is not intended to be a loan to the plan and is otherwise discouraged is permissible; 102 however, the implication is that overdrafts that are structured as a loan to the HSA and are otherwise encouraged would be a prohibited transaction. An HSA custodian or trustee s offering of an inducement to the Account Beneficiary to establish an HSA. The DOL has ruled that free checking services for an IRA Account Beneficiary (i.e., a fiduciary) who establishes an IRA with a particular bank constitutes a prohibited transaction because the fiduciary in this situation is receiving consideration for his own personal account from a person dealing with the IRA assets. 103 But as noted above, this ruling would not apply to HSAs in the absence of a formal exemption issued by DOL. Planning Pointer: Since an Account Beneficiary may only receive a distribution up to his/her account balance, many HSA vendors consider offering Account Beneficiaries lines of credit or credit cards to enable them to pay for expenses in excess of the HSA account balance. While certain activities are clearly prohibited (e.g., borrowing or pledging the HSA assets, or receiv[ing] a benefit in his or her own individual capacity as a result of opening or maintaining an HSA ) the mere issuance of credit by an HSA vendor in an arms length transaction and the Account Holder s directing HSA funds to the credit line vendor for HSA expenses paid with a credit card are not automatically prohibited according to the DOL. 104 Of course, credit could not be issued on the condition that the Account 48

50 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Holder assign his rights to HSA funds to the credit line vendor, as such an assignment would constitute an impermissible pledging of the account as security for a loan (see below), but voluntary, revocable payments directed by the Account Holder to the credit line vendor do not appear to be automatically impermissible. Whether a prohibited transaction occurs depends on the particular facts and circumstances. It seems that traditional banking overdraft practices may be permitted under the conditions described in DOL Advisory Opinion A. However, an HSAbased line of credit with recourse against the HSA (or for that matter even a right of set-off against an HSA) may be problematic. With regard to the inducement issue, DOL refers to DOL Adv. Op A as general guidance. In 89-12A, the DOL held that offering free checking services to IRA account holders who invest a portion of the IRA assets with bank owned mutual funds was a prohibited transaction. This would likely be considered a use of the plan or HSA assets for the individual s own benefit in violation of Section 4975((c)(1)(D), (E), or (F) of the Code. Although not directly applicable to HSAs, the concept set forth in the 89-12A and the subsequent IRA rulings is that it is a prohibited transaction to provide an HSA Account Holder with consideration for his personal account as a result of establishing or maintaining an HSA or for using HSA funds. Penalties for Prohibited Transactions Typically, the penalty under the Code for a prohibited transaction is a tax of 15 percent of the amount involved or, if not corrected within the year, 100 percent of the amount involved; however, the Code appears to exempt account beneficiaries who commit prohibited transactions from the Code Section 4975 excise tax. 105 Instead, as stated above, if the Account Beneficiary commits a prohibited transaction, the account ceases to be an 49

51 BANKING LAW JOURNAL HSA as of the first day of the year in which the prohibited transaction occurred and the fair market value of the HSA as of that date is treated as taxable distribution (and additional excise taxes for an early distribution would likely apply). On the other hand, a custodian/trustee would be subject to the Code Section 4975 penalty on the amount involved for prohibited transactions that it commits. The amount involved is the greater of the amount of money and the fair market value of the other property given or the amount of money and the fair market value of the other property received. 106 Where the use of money is involved (i.e., a loan), the regulations define the amount involved as the greater of the amount paid for such use or the fair market value of such use. 107 A prohibited transaction is corrected by undoing the transaction to the extent possible, but in any case placing the account in as good a financial position as it would have been in had the individual acted in accordance with the highest fiduciary standards. 108 Where the prohibited transaction is the lending of money, the disqualified person corrects the transaction by repaying the principal plus reasonable interest. 109 Pledging the Account as Security Code Section 408(e)(4) indicates that if an Account Beneficiary uses the account or any portion of the account as security for a loan, the portion used as security is treated as distributed to that individual. Code Section 223(e)(2) indicates that such amounts are treated as a taxable distribution. The scope of circumstances under which the HSA would be deemed to be pledged as security for a loan is not clear. HSAs offered with a line of credit or a credit card are becoming more and more popular. Conservative custodian/trustees will avoid arrangements whereby the credit is provided solely on condition that the Account Beneficiary assign his/her interest in the HSA as security for repayment of the credit. Such conservative custodian/trustees will not condition the credit on assignment of HSA funds but may likely allow account beneficiaries to use, at their discretion, the HSA funds (or to allow the HSA custodian/trustee to withdraw) provided the Account Beneficiary can repay such credit with other funds. 50

52 HSA REPORTING REQUIREMENTS HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Custodian/trustees and employers each have reporting requirements to the IRS and the Account Beneficiary. Also, account beneficiaries have a reporting requirement for HSA distributions. This section discusses the specific HSA reporting requirements for trustees/custodians, employers, and Account Beneficiaries. Reporting Requirements for Trustee/Custodians HSA trustees/custodians are subject to the following reporting requirements: Form 1099-SA to the IRS and the Account Beneficiary Form 5498-SA to the IRS and the Account Beneficiary Form 1099-SA The Form 1099-SA reports all gross distributions from the HSA during the year as well as excess contributions and the earnings on any such excess contributions that are returned to the Account Beneficiary. Gross distributions includes any distributions made directly to the Account Beneficiary or to a health care provider as well as distributions made during the year on account of the beneficiary s death and deemed distributions resulting from prohibited transactions. Each 1099-SA must identify on Box 3 of the 1099-SA a distribution code from a list of 6 distribution codes set forth in the instructions to SA. Each specified distribution code describes the various circumstances under which a distribution is being made (and also gives the IRS some indication which distributions might be taxable). Most distributions made during the year to or on behalf of an Account Beneficiary are considered normal distributions and there is a specific distribution code attendant to normal distributions. 110 In the case of other situations where a distribution is made or deemed made, there are other distribution codes identified in the instructions to the Form 1099-SA. You should also note that trustee-to-trustee transfers (e.g., where an 51

53 BANKING LAW JOURNAL Account Beneficiary requests funds from one HSA be transferred to another HSA directly) are not considered distributions and should not be reported as distributions on a 1099-SA. The following is a discussion of the types of distributions that must be reported on a Form 1099-SA. Distributions on Account of the Account Beneficiary s Death If the HSA Account Beneficiary dies during the year and the surviving spouse is the beneficiary, then the surviving spouse steps into the shoes of the original, deceased Account Beneficiary and the surviving spouse is considered to be the Account Beneficiary of the HSA. There is no distribution to report solely as a result of the original Account Beneficiary s death where the surviving spouse is the designated beneficiary; however, the surviving spouse would receive a 1099-SA in the same manner that the deceased original Account Beneficiary would have received but for his/her death. It is important to note that HSA rules require the account to be treated as the surviving spouse s account as of the date of the death; however, the rules do not require the custodian/trustee to continue the HSA in the name of the surviving spouse. In accordance with the custodian/trustee s rules for maintenance and/or termination of the HSA, the custodian/trustee may condition continuation of the HSA in the name of the surviving spouse on the spouse s satisfaction of certain conditions; in fact, federal laws such as the Patriot Act may require that certain conditions be satisfied before approving the spouse as an Account Beneficiary. The custodial/trust agreement should describe the requirements that the surviving spouse must satisfy in order for the surviving spouse to continue the account in his/her name. On the other hand, if the HSA balance is transferred at death to anyone other than the spouse, or no beneficiary is named such that the HSA balance is transferred to the deceased s estate, the HSA ceases to be an HSA on the date of the death and there is a deemed distribution equal to the fair market value of the HSA as of the date of the death. The recipient of the deemed distribution is the non-spouse beneficiary or the estate, whichever the case may be. The fair market value of the HSA as of the date of the death is reported in Box 4 and there is a specific distribution code for such distribu- 52

54 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL tions. 111 The HSA ceases to be an HSA as of the date of the death if the spouse is not named as a beneficiary; however, notice of the Account Beneficiary s death might not occur until some time after the death. No guidance has been provided regarding the trustee/custodian s treatment of the account and its funds following the date of death for reporting purposes. It will not be unusual for an Account Beneficiary to transfer a portion of the HSA to the spouse and the remaining portion to one or more non-spouse death beneficiaries (or to no other beneficiaries). In that case, the surviving spouse is presumably considered to be the Account Beneficiary with regard to the portion of the HSA transferred to the spouse and the remaining portion is considered distributed to the other non-spouse beneficiaries (or if 100 percent was not distributed to the spouse and no other beneficiary was named, to the estate) and a 1099-SA is prepared and distributed accordingly. Deemed Distributions Arising from Prohibited Transactions and Security Interests Code Section 223(e)(2) indicates that rules similar to IRA rules described in Code Section 408(e)(2) [relating to prohibited transactions] and (4) [relating to pledging HSA amounts as security/collateral for a loan] apply to HSAs (and that such amounts will not be deemed to have been used for qualified medical expenses). 112 Code Section 408(e)(2) essentially indicates (using HSA speak as opposed to IRA speak) that if an Account Beneficiary engages in a prohibited transaction described in Code Section 4975 (discussed above) at any time during the Account Beneficiary s taxable year, then the account ceases to be an HSA as of the first day of such taxable year (i.e., its status as an HSA is automatically terminated) and the fair market value of all assets in the HSA, as of the first day of such taxable year, is treated as distributed to the Account Beneficiary. This amount must be reported on the 1099-MISC and there is a special distribution code for such distributions. 113 Note the timing of the valuation of the distribution it is as of the beginning of the tax year, regardless of when the prohibited transaction occurs or any increase or decrease in value of the HSA after the first day of such year. All other trans- 53

55 BANKING LAW JOURNAL actions after the first day of that taxable year are treated as other than HSA transactions (and none of the tax advantages of the HSA would apply to the contributions, earnings or distributions occurring after such date) and the applicable reporting requirements would apply (e.g., an HSA with a bank would likely be treated as any other checking account). Code Section 408(e)(4) indicates that any amounts from the HSA that are pledged by an Account Beneficiary as security for a loan during the taxable year are considered distributed to the Account Beneficiary for other than qualified medical expenses. Unlike the consequences arising from prohibited transactions, the HSA is not terminated by default and only the affected amounts are treated as distributed. Since there is no specific distribution code, it is presumably treated as any other normal distribution. While a custodian/trustee is required to report such distributions arising from prohibited transactions and, presumably, amounts arising from pledging the HSA as security for a loan, that obligation presumably only arises if the custodian has knowledge of such a prohibited transaction or security interest. Excess Contributions and Earnings on Excess Contributions If contributions are made to an HSA during the year that exceed the Annual Contribution Limit, such contributions are subject to an excise tax of six percent unless such amounts, and any earnings on such amounts, are withdrawn from the HSA by the Account Beneficiary before the Account Beneficiary s federal income tax return due date, including any extensions, for that tax year. 114 Excess contributions and earnings on excess contributions are discussed in more detail elsewhere in this article. Any such returned excess contributions and earnings associated with the excess contributions must be reported on the Form 1099-SA. There is a specific distribution code for excess contributions. 115 As noted earlier, it appears that the custodians/trustees have no reporting obligation with regard to excess contributions withdrawn by the Account Beneficiary unless the Account Beneficiary affirmatively informs the custodian/trustee that such withdrawal is an excess contribution. Custodians/trustees are not required to monitor the Annual Contribution 54

56 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Limit of each Account Beneficiary. 116 The custodian/trustee is merely obligated to ensure that it does not accept more than the Statutory Maximum Annual Contribution for family coverage without regard to the level of coverage the individual actually has, plus any Catch -Up Contribution that may be applicable due to age. 117 Thus, for 2008, the trustee need only be sure that it does not accept more than $5,800 (plus $900 if the individual will be age 55 before the end of the year), even if the individual has single coverage under an HDHP (thus the contribution limit would be $2,900). If the individual makes a withdrawal of an excess contribution from the HSA, the custodian/trustee will not know that it is an excess contribution withdrawal unless it is told. Mistaken Distributions Notice clarifies that custodian/trustees may, but are not required to, allow account beneficiaries to return distributions if the Account Beneficiary reasonably, but mistakenly, believed that the expense for which the distribution was taken was a qualified medical expense (or other reasonable cause). 118 Such amounts are not treated by the IRS as a distribution or a contribution. However, there is currently no procedure for addressing mistaken distributions on the Form 1099-SA. Presumably, the HSA trustee/custodian would make adjustments to its system to offset the prior distribution and to ensure the re-deposit of the mistaken distribution is not treated as a contribution for the year. Such adjustments will be problematic where the mistaken distribution is discovered after the Forms 5498 and 1099 have been issued for a year. HSA trustees/custodians may want to limit the return of mistaken distributions to the calendar year. Fees Withdrawn Directly from the HSA How should custodian/trustees treat fees that are withdrawn directly from the account? Are they distributions that must be reported on the 1099? Notice , Q/A-69 makes it clear that such fee withdrawals are not considered to be taxable distributions; however, it does not indicate whether such withdrawals must be reported by the custodian/trustee as a distribution from the HSA. Form 1099-SA is also silent as to how such fee withdrawals 55

57 BANKING LAW JOURNAL should be treated. Technically, it appears as though such a withdrawal is a distribution ; however, in looking at Form 8889 (the form that the Account Beneficiary must file with his/her individual tax return), the IRS fails to address how the Account Beneficiary should treat such withdrawal/distributions. While it is clear in Notice that fees withdrawn directly from the account are non-taxable, it would make sense that Form 8889 would inform the Account Beneficiary of this rule. Form 8889 indicates that only distributions for qualified medical expenses are tax free. If such amounts are included as distributions on the Form 1099-SA and thus reported as distributions on the Form 8889, and the Form 8889 does not properly address such fee withdrawals (it could indicate that fees to maintain the HSA should be treated the same as qualified medical expenses, but it does not), they will show up as taxable distributions. Additional guidance would be welcome in this area. When to file and to whom? Copy A of 1099-SA must be filed with the IRS by no later than February 28 following the reporting year or, if filed electronically, no later than March 31. Copy B of the Form 1099-SA must be furnished to the recipient by no later than January 31 following the reporting year. Form 5498-SA Form 5498-SA reports the following contributions: Contributions made during the tax year for the tax year (e.g., 2008 contributions for 2008), Contributions made in the following tax year (but before the due date of the Account Beneficiary s tax return, without extensions) for the tax year (e.g., contributions made in 2007 but before April 15, 2008 for ), Contributions made during the tax year for the prior tax year (contributions made in 2008 for 2007), including Qualified HSA Funding Distributions, and Rollover contributions from another HSA, Archer MSA or Qualified 56

58 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL HSA Distribution (i.e., a rollover from a Health FSA or an HRA). Note that custodians/trustees do not report trustee-to-trustee transfers on Form 5498-SA. Custodian/trustees should be aware of a few practical issues with respect to the Form 5498-SA: Does a custodian/trustee have to send a Form 5498-SA for tax years prior to the date the HSA is established with the custodian/trustee if the contributions are allocated to a prior year? For example, assume Joe is an Eligible Individual (as defined in Code Section 223(d)(1)) during 2005; however, Joe does not open up an HSA with America s Bank until January 1, Joe makes a contribution on January 1, 2006 but he allocates the contribution to the 2005 plan year (so that he can take a deduction on his 2005 tax return). 120 Does America s Bank have to file a Form 5498-SA for 2005? The instructions to the Form 5498-SA indicate that a custodian/trustee must file a Form 5498-SA for each HSA that it maintains during the year. Moreover, the fact that the 2006 Form 5498-SA will include contributions made in 2006 for the 2005 year would seem to support the argument that America s Bank would not have to file a 2005 Form 5498-SA for Joe s HSA. On the other hand, it is also logical that America s Bank would have to furnish a 2005 Form 5498-SA to Joe so that Joe could properly complete his 2005 tax return. The answer is not clear. Custodian/trustees will want to ensure that its contribution forms ask the Account Beneficiary to identify contributions that are rollover contributions so that the custodian/trustee can properly report such contributions. The same holds true for Qualified HSA Distributions and Qualified HSA Funding Distributions the custodian must be able to identify these transfers to the HSA from other contributions (e.g., the Qualified HSA Distribution should be distinguished from other contributions made during the year because they are treated as rollover contributions. Likewise, Qualified HSA Funding Distributions should be distinguished because they are not treated the same as other trustee-totrustee transfers). See the accompanying chart identifying the various 57

59 BANKING LAW JOURNAL reporting requirements for Qualified HSA Distributions and Qualified HSA Funding Distributions. Even if no contributions are made during the year, the Form 5498-SA must still be provided if the HSA has a balance the custodian is required to report the fair market value of the HSA as of December 31 each year. The instructions clarify that the only time that a Form 5498 is not required for an HSA that has a balance during the year is if all HSA funds are distributed prior to the last day of the year and no contributions are made. Copy A of Form 5498-SA must be filed with the IRS by May 31 of the year following the tax year being reported. Copy B must also be furnished to the Account Beneficiary by May 31. In addition, the custodian/trustee may, but is not required to, furnish to the Account Beneficiary a copy of the Form 5498-SA showing the fair market value of the HSA on December 31 by the following January 31. Disclosure Statement IRA custodian/trustees must issue a disclosure statement to all account beneficiaries. 121 No such specific requirement exists for HSAs but many custodian/trustees provide a disclosure statement that accompanies the trust/custodial agreement and that provides a general summary of the rights and obligations of the Account Beneficiary and custodian/trustee as set forth in the custodial/trust agreement. The trustee/custodian has no other HSA specific reporting requirements. There is no requirement to file copies of the custodial or trust agreement. The custodian may, however, have other forms that it has to complete as part of the HSA application process that are not HSA specific, such as a Form W- 9 (Form to request taxpayer identification number for all entities required to file a tax form). Also, if the HSA is subject to ERISA, the custodian/trustee may only be required to assist the employer with completing the Form 5500; however, the if the arrangement is structured in such a way that the custodian/trustee is named as the plan administrator of the HSA, the custodian/trustee will actually be required to file the Form See below 58

60 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL for more information on Form 5500 filing requirements. Employer HSA Reporting Requirements Generally speaking, the employer is subject to the following reporting requirements: For employees the employer must report its contributions to employees on a Form W-2. A partnership must report its contributions to partners on a Schedule K- 1 (Form 1065). Form W-2 A Form W-2 is filed with the IRS to report wages paid to an employee from which income, social security and Medicare taxes are generally withheld (or would be withheld but for a claimed exemption from withholding on Form W-4) as well as other non-cash remuneration such as fringe benefits. 122 Employers must report on the W-2 the employer s contributions made to their employee s HSAs during the calendar year. Non-taxable employer HSA contributions are reported in Box 12 and the applicable Code is W. 123 There are a couple of practical issues of which employers should be aware with regard to the W-2: The employer is required to not only report non-elective employer contributions made to the HSA during the year but the employer is also required to report on the W-2, as employer contributions, the employee s pre-tax salary reductions made through the cafeteria plan. 124 This is because the IRS considers pre-tax salary reductions to be employer contributions. 125 For example, assume that the employer contributes $500 to the employee s HSA. The employee also elects to reduce his/her salary on a pre-tax basis through the Code Section 125 plan by $1,000. The employer would report $1,500 in Box 12 (and identify such contributions as HSA contributions with the appropriate code, W ). HSA rules allow contributions to an HSA to be made for a year at any 59

61 BANKING LAW JOURNAL time prior to the employee s tax return due date, without extensions, for that year. 126 Thus, contributions can be made for 2007 as late as April 15, The W-2 instructions indicate that the W-2 reports wages [or the equivalent thereof] paid during the year. The Form W-2 does not technically account for situations (at least in a technical sense) where the employer makes contributions in one year but allocates them to the prior year, and frankly this can cause problems for the otherwise do-good employer. For example, assume that the employer decides on February 28, 2007 to make a contribution to the employees HSAs and to allocate those contributions to the 2006 calendar year. Would the contributions be properly reported on the 2005 W-2 (thus requiring the employer to amend the W-2s already furnished to employees) or on the 2006 W-2 since the contributions are actually made during 2006 (despite the fact that they are for 2005)? If you read the W-2 instructions literally, it would appear that the contributions must be reported on the 2006 W-2; however, if the employer decides to contribute the maximum annual contribution amount for the 2006 year, the 2006 W-2 will show contributions in excess of the maximum for Conservative plan sponsors will make their HSA contributions on or before December 31 of each year. Those that do make contributions in one year but allocate them to another year will want to consult with qualified tax or legal counsel to determine the appropriate Form W-2 reporting requirements. When to file and to whom? Copy A of Form W-2 must generally be filed with the IRS by employers for all employees to whom it paid wages (even if the employer made no HSA contributions for an employee) no later than February 28 following the year which is being reported (March 31 if you file electronically). 127 In addition, Copy B of the W-2 must generally be furnished to employees by January 31 following the reporting year (extensions may be granted in certain situations). 128 Schedule K-1 (Form 1065) If a partnership makes contributions to a partner s HSA, then the contributions are included in the partner s gross income and reported on 60

62 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Schedule K-1 (Form 1065). There is no requirement to specifically identify the contributions as HSA contributions on the Schedule K-1 (they are simply included with all other gross income). Contributions made by a partnership to a partner s HSA will impact the amount on the K-1 even if the contributions are not specifically identified as HSA contributions on the Form. If the contributions are treated as distributions, then they are reported as distributions of money on the Schedule K If they are treated as guaranteed payments, then they are reported as guaranteed payments on the Schedule K What Are the Reporting Requirements for Account Beneficiaries? Account Beneficiaries essentially have two reporting obligations: Form 8889 that is filed with the individual s federal Form 1040; and Form 5329 that is filed with the IRS to report excess contributions. Form 8889 The Form 8889 is used by an Account Beneficiary to report contributions to and distributions from an HSA during the calendar year. There are two parts to the Form Part I reports various information regarding contributions and Part II reports various information regarding distributions. It is on this form that account beneficiaries report the information provided to the Account Beneficiary by the Account Beneficiary s employer (where applicable) and the custodian/trustee as described in more detail above. The Form 8889 is attached to a Form The Account Beneficiary does not attach copies of the Form 1099-SA, 5498-SA and W-2 to the Form Note that an Account Beneficiary otherwise required to file a Form 8889 must file a Form 1040; the Account Beneficiary cannot file a Form 1040A or EZ. Essentially, any Account Beneficiary who meets any of the following criteria must complete and file a Form 8889: The Account Beneficiary made contributions to an HSA during the cal- 61

63 BANKING LAW JOURNAL endar year (excluding rollover contributions) or someone made contributions to the Account Beneficiary s HSA on the Account Beneficiary s behalf; Distributions from the Account Beneficiary s HSA were made during the calendar year; and The Account Beneficiary acquired an interest in an HSA during the year. See below (and elsewhere in this article) for reporting rules in the event of the Account Beneficiary s death. A husband and wife who each maintain an HSA must each file a Form 8889, even if they file jointly. 131 Special rules for married individuals with regard to reporting contributions are discussed elsewhere in this article. If the spouse is the sole designated death beneficiary, then the spouse files the Form 8889 as though the spouse was the Account Beneficiary for the entire year. If the beneficiary is someone other than the spouse, the beneficiary completes the Form 8889 in accordance with the instructions on Form 8889; however, the beneficiary does not need to complete Part I of the form (relating to contributions) unless the beneficiary is the estate. Form 5329 Account beneficiaries report any excess contributions on Line 42 of the Form 5329 unless such excess contributions (and earnings) were timely withdrawn. The Form 5329 is attached to the Form

64 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL QUICK-REFERENCE CHART OF HSA COMPLIANCE ISSUES This matrix is intended to provide basic knowledge of the major laws that impact the provision of services by trustees and custodians in connection with health savings accounts ( HSAs ) Source 31 USC Sec et seq.; 31 CFR 103 Law, Regulation or Ruling Bank Secrecy Act/Patriot Act The Bank Secrecy Act ( BSA ) is a tool by which the US government prevents regulated financial institutions (e.g., banks, insurance companies) and other non-regulated financial service providers from being used as intermediaries for, or to hide the transfer or deposit of money derived from, criminal activity. The BSA requires financial institutions and therefore their service providers to: (1) report currency transactions involving amounts over $10,000 to the Financial Crimes Enforcement Network ( FinCEN ) of the Treasury Department on Currency Transaction Reports; (2) keep records of funds transfers involving amounts over $3,000; and (3) report suspicious transactions and known or suspected criminal federal violations to FinCEN on Suspicious Activity Reports. The Patriot Act, which amended the BSA, requires all U.S. financial institutions to establish anti-money laundering programs ( AML Programs ). Specifically, Section 352 of the Patriot Act amended the BSA to require all U.S. financial institutions to adopt an AML Program containing four minimum elements: (i) internal policies, procedures, and controls; (ii) a designated AML compliance officer; (iii) 63

65 BANKING LAW JOURNAL Source Law, Regulation or Ruling an on-going employee training program; and (iv) an independent audit function to routinely test the AML Program. In addition, the Patriot Act requires financial institutions (directly or through their service providers) to employ procedures designed to verify the identity of persons that open accounts, including consulting lists of blocked and restricted persons, entities, and geographic locations prior to opening such accounts and prior to engaging in certain types of transactions. Financial institutions are also required to consult these lists before sending money to and, in some cases, receiving money from foreign jurisdictions, governments, entities, and persons. Financial institutions are required to maintain records of the information used to verify the identity of their customers as well as maintain records of certain types of transactions. International Emergency and Economic Powers Act ( IEEPA ); Trading with the Enemy Act ( TWEA ); Cuban Democracy Act ( CDA ); and other Legislation OFAC / US Economic Sanctions The Office of Foreign Assets Control ( OFAC ) of the US Department of the Treasury administers and enforces economic and trade sanctions against targeted foreign countries, terrorism sponsoring organizations, and international narcotics traffickers based on US foreign policy and national security goals. All banks located in United States, overseas branches of US banks, and overseas subsidiaries of US banks must comply with economic sanctions and embargo programs administered under regulations issued by OFAC. These regulations prohibit doing business with, maintaining accounts for, or handling transactions or monetary transfers for foreign countries (e.g., Cuba, Iran, Sudan, Burma) or foreign nationals list- 64

66 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Source Law, Regulation or Ruling ed on OFAC s list of Specially Designated Nationals and Blocked Entities. 12 CFR Sec. 204 Reserve Requirements of Depository Institutions (Reg. D) Regulation D, promulgated by the Board of Governors of the Federal Reserve System ( Federal Reserve or Board ) requires depository institutions to maintain reserves against their customers transaction accounts and nonpersonal time deposits. Transaction account is defined to include, among other things, demand deposit accounts (e.g., checking accounts) and NOW accounts. 12 CFR Sec. 205 Electronic Fund Transfer Act (Reg. E) Regulation E, promulgated by the Board, sets rules, liabilities, and procedures for electronic funds transfers ( EFT ), and establishes consumer protections using EFT systems. This regulation prescribes rules for solicitation and issuance of EFT debit cards, governs consumer liability for unauthorized transfers, and requires financial institutions to disclose annually the terms and conditions of EFT services. The Federal Reserve, in a recent amendment to Regulation E, has clarified that cards linked to HSAs are not subject to the regulation. However, the Fed has indicated that it will monitor such health benefit cards to ensure the continued appropriateness of this exemption. 65

67 BANKING LAW JOURNAL Source 12 CFR Sec. 210 Law, Regulation or Ruling Collection of Checks and Other Items by Federal Reserve Banks and Funds Transfers Through Fedwire (Reg. J) Regulation J establishes procedures, duties, and responsibilities among (1) Federal Reserve Banks, (2) the senders and payors of checks and other items, and (3) the senders and recipients of wire transfers of funds. 12 CFR Part 216 (FRB); 12 C.F.R. Part 573 (OTS); 12 C.F.R. Part 40 (OCC); 12 C.F.R Part 332 (FDIC) GLBA Consumer Privacy Protections The Gramm-Leach-Bliley Act and its implementing regulations prohibit a financial institution from disclosing nonpublic personal information to third parties that are not affiliated with the financial institution. These rules require banking and non-bank financial institutions to provide notice to their consumer (i.e., non-business) customers about their privacy policies and practices and the right of a consumer to prevent a financial institution from disclosing nonpublic personal information about him or her to nonaffiliated third parties by opting out of information sharing.. In addition, federal bank regulatory agencies require financial institutions to include certain provisions in their contracts with third party service providers that prohibit the third party from disclosing or using customer information other than to carry out the purposes for which the bank disclosed the information. 66

68 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Source 12 CFR Parts 208, 211, 225, 263 (FRB); 12 C.F.R. Parts 568, 570 (OTS); 12 C.F.R. Part 30 (OCC); 12 C.F.R Parts 308, 364 (FDIC) Law, Regulation or Ruling Interagency Guidelines Establishing Standards for Safeguarding Customer Information The Safeguard Rule requires financial institutions to (i) insure the security and confidentiality of customer information; (ii) protect against any anticipated threats to the security or integrity of customer information; and (iii) protect against unauthorized access. These Interagency Guidelines also require financial institutions to use contract provisions and oversight mechanisms to protect the security of customer information handled by service providers. 12 CFR Sec. 218 Exceptions for banks from the definition of ''broker'' in the Securities Exchange Act of 1934 (Reg. R) Regulation R implements the provisions of the Gramm-Leach-Bliley Act which repealed the temporary blanket exemption from broker-dealer registration previously applicable to banks and replaced it with several exceptions for specified securities-related activities that banks may engage in without being considered a broker, which activities would otherwise require such activities to be conducted by a registered broker-dealer. 12 USC 371c; and 12 CFR Sec. 223 Federal Reserve Act, Section 23A, Affiliate Transactions (Reg. W) Section 23A of the Federal Reserve Act imposes certain quantitative and qualitative limits on transactions between a bank and any of its affiliates. Under 67

69 BANKING LAW JOURNAL Source Law, Regulation or Ruling section 23A, covered transactions with any one affiliate may not, in the aggregate, exceed 10 percent of the bank s total capital, and the bank s total transactions with all affiliates are limited to 20 percent of total capital. It also requires that covered transactions be consistent with safe and sound banking practices and secured by certain collateral amounts. 12 USC 371c; 12 USC 371c-1; and 12 CFR Sec. 223 Federal Reserve Act, Section 23B, Affiliate Transactions (Reg. W) Section 23B of the Federal Reserve Act, like section 23A, imposes restrictions on certain transactions with affiliates. A bank and its subsidiaries may only engage in certain transactions with an affiliate if the transaction is under comparable terms and circumstances as those involving non-affiliated companies. In the absence of comparable transactions, the transaction should be under terms and circumstances that are made in good faith. 12 USC 4001 et seq. 12 CFR Sec. 229 Expedited Funds Availability Act (EFAA)(Reg. CC) This federal act and its implementing regulation limits check holds on checks deposited into a bank account, and requiring banks and other depository financial institutions to follow a uniform funds availability schedule in processing checks or drafts deposited into an account. 68

70 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Source 12 CFR Sec. 230 Law, Regulation or Ruling Truth in Savings (Reg. DD) The Truth in Savings Act ( TISA ) and its implementing regulation establish uniformity in the disclosure of terms and conditions regarding interest and fees for new and existing savings accounts so that consumers are able to make a meaningful comparison between potential depository institutions. It also imposes certain requirements for advertising, record retention and electronic forms of communication. 12 USC Sec Right to Financial Privacy Act The RFPC was enacted to provide protection against unrestricted access to financial records by balancing the interest of financial institution customers and federal agencies seeking to discover such records. 12 USC Sec and 12 CFR 360 Federal Deposit Insurance ( FDI ) Act This Act, among other things, creates the Federal Deposit Insurance Corporation as well as a deposit insurance fund which insures certain specified accounts at member depository institutions. Public Law (aka HIPAA) Health Insurance Portability Administration Act of 1996 ( HIPAA ) The Health Insurance Portability and Accountability Act ( HIPAA ) is a federal law that (i) mandates the use of standards for the electronic exchange of health care data; (ii) specifies what medical and administra- 69

71 BANKING LAW JOURNAL Source Law, Regulation or Ruling tive code sets should be used within those standards; (iii) requires the use of national identification systems for health care patients, providers and payers (or plans), and employers (or sponsors); and (iv) specifies the types of measures required to protect the security and privacy of personally identifiable health care information ( PHI ). HIPAA obligations should not generally apply with regard to a custodian/trustee s handling of HSAs. However, certain employers may treat their HSAs as being part of their group health plan which would impose on them an obligation to have a business associate agreement ( BAA ) in place with custodian/trustee. IRC Sec 223 Section 223 sets forth the substantive requirements for a trust or custodial account intended to qualify as a health savings account ( HSA ). IRS Model Trust (5305B) and Custodial (5305C) forms are available, IRC 223 requires that contributions be in cash; forbids investment in life insurance contracts; prohibits commingling of assets for investment purposes except for common trust fund or common investment fund; regulates when HSA account is "established"; governs amounts contributed and treatment and reporting of contributions; generally forbids withdrawals from HSAs (e.g., due to mistaken contributions) that are not initiated by Account Holder. IRC 4975 Tax Prohibited Transaction Rules The tax prohibited transaction rules found in IRC 4975 prohibit certain transactions including inducements to the HSA Account Holder (e.g., 70

72 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Source Law, Regulation or Ruling relationship banking perks) and certain related party dealings with the HSA account (e.g., receipt of additional compensation above and beyond account maintenance fee without disclosure to and approval by HSA Account Holder); requires that HSA funds be timely credited to accounts; prohibits bundled arrangements whereby HSA subsidizes (or is subsidized by) other services; generally forbids using HSA as security and/or borrowing against HSA. IRC Sec. 6041; Tax Reporting (Form 1099SA and Form 5498SA) The 1099SA form is the Internal Revenue Service s tax form used for HSA custodians and trustees to report all distributions from HSA accounts (other than direct trustee-to-trustee transfers). The form is sent both to the taxpayer and to the IRS. Any amounts reported on the 1099SA must be reported on the individual s tax returns as well. The Form 5498SA is an annual report of HSA contributions and FMV of HSA account. The form is sent both to the taxpayer and to the IRS. National Automated Clearing House Association ( NACHA ) ACH Rules The NACHA rules and guidelines specify the rights and obligations of each participant to an electronic payment or electronic information transaction processed through the Automated Clearing House ( ACH ) Network. Electronic payments covered by the rules include. These rules apply to debits and credits automatically processed to a consumer s 71

73 BANKING LAW JOURNAL Source Law, Regulation or Ruling deposit account in a variety of contexts, including electronic bill and invoice presentment and payment ( EBPP, EIPP ), e-checks, financial electronic data interchange ( EDI ), international payments, and electronic benefits services ( EBS ). 29 CFR Part 2584 and 29 USC Ch. 18 Employee Retirement Income Security Act ( ERISA ) The Employee Retirement Income Security Act ( ERISA ) is a federal statute that establishes minimum standards for employee benefit plans in private industry. The goal of ERISA is to protect the interest of employee benefit plan participants and their beneficiaries by requiring the disclosure to them of financial and other information concerning the plan by establishing standards of conduct for plan fiduciaries and by providing for appropriate remedies and access to the federal courts. Prohibited transaction rules under ERISA parallel those applicable under IRC USC 78a et seq. Securities Exchange Act of 1934 ( Act of 34 ) Governs prospectus and proxy statement delivery requirements. Financial Industry Regulatory Authority ( FINRA ) FINRA Rules Governs conduct of member broker-dealers; restricts sharing of transaction based compensation; governs disclosure of fees received; governs sale of mutual funds. 72

74 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Source 15 USC 80b-1 through 15 USC 80b-21 Law, Regulation or Ruling Investment Advisors Act of 1940 The Act defines what an investment adviser is, requires such advisors to register with the SEC, and sets standards for advertising, disclosure, fees, liability, and record keeping 15 USC 80a-1 through 15 USC 80a-64 Investment Company Act of 1940 The Act regulates conflicts of interest in investment companies and securities exchanges. It protects the public primarily by requiring disclosure of material details about investment companies, including: Governing approval and use of Rule 12b-1 fees by mutual fund boards for distribution and shareholder servicing; and Dictating disclosures by fund companies on such things as investment objectives, risks, and expense. Card Association (e.g., Visa or MasterCard) Rules Card Association Rules Card association members (e.g., card issuers, acquiring banks, certain third party processors) are obligated at all times to comply with Card Network rules. These rules frequently limit those transactions permissible for processing through the system, prescribe transaction codes, impose processing time frames, and apportion liability among members for fraudulent and reversed transactions. 73

75 BANKING LAW JOURNAL Source 15 USC 78aaa et seq. Law, Regulation or Ruling Securities Investor Protection Corporation ( SIPC ) Insures securities and cash in the customer accounts of member brokerage firms against the failure of those firms. State Laws (e.g., state money transmitter, abandoned property laws, etc.) State Laws Escheatment (inactive/dormant accounts) Deceased depositor (passing of account assets to survivors) Domestic relations (spousal consent) Security Breach of Medical and Health Insurance Information (notice to consumers in the event of data security breach) State-specific privacy laws (that modify the consumer protections afforded by federal privacy laws) State money transmitter laws 74

76 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL NOTES 1 The Banking Law Journal, Vol. 125 No. 1 (January 2008). 2 Public Law (December 23, 2003). A copy of the Act is at 3 A listing of the technical guidance issued by the IRS is at offices/public-affairs/hsa/technical-guidance/. 4 The 2006 Act is actually Title III of the Tax Relief and Health Care Act of 2006, Public Law, , enacted as H.R and signed by President Bush on December 20, A list of the technical guidance issued by the DOL is at 6 As this article goes to press, Congress is considering legislation (the Taxpayer Assistance and Simplification Act of 2008 (H.R. 5719)) that would impose a medical claims substantiation requirement on HSA trustees/custodians. 7 Residents of the U.S. Virgin Islands, Guam, and the Commonwealth of the Northern Mariana Islands may establish HSAs; however, residents of Puerto Rico and American Samoa may only establish HSAs (on a tax-advantaged basis) after provisions similar to Code Section 223 have been adopted under their respective tax codes. 8 Internal Revenue Code Section 223(c)(1). 9 Notice , Q/A Notice , Q/A FSAs and HRAs are other forms of individual account-based health coverage. HRAs were first recognized by IRS in a 2002 ruling (IRS Rev. Rul , July 15, 2002). Health FSAs have been in existence since the 1980s and are recognized by proposed regulations issued under Section 125 of the Code. Unlike HSAs, FSAs and HRAs are actually employer-sponsored group health plans and thus are subject to the full panoply of group health regulatory requirements (ERISA, HIPAA, etc.). As noted above, if substantially all of the coverage in a health plan that is intended to be an HDHP is provided through an FSA or HRA, the health plan is not an HDHP, even if it imposes a deductible that satisfies the Statutory Minimum Annual Deductible. 12 For 2007 the amount was the same. For 2006, the Statutory Minimum Annual Deductible was $1,050 for self-only coverage and $2,100 for family coverage. 13 Code Section 223(b)(2). 14 Notice Q/A Notice Q/A Notice Q/A

77 BANKING LAW JOURNAL 17 Notice Q/A Notice Q/A Code Section 223(g). Cost-of-living adjustments are based, in part, on the Consumer Price Index published by the DOL. 20 Code Section 223(c)(3); see also Notice Q/A-6 and Notice Q/A Notice Q/A Notice Q/A As defined in Notice Internal Revenue Code Section 223(d)(1)(A). 25 Notice Q/A Notice Q/A Code Section 223(d)(1)(B); see also Notice Q/A-72 (corrected version issued August 10, 2004). 28 Notice Q/A-9; see also Treas. Reg (e). 29 Treas. Reg (e)(1) through (5). 30 One can find this (and other Frequently Asked Questions) at 31 Notice Q/A 28; note that Notice , Q/A-11 indicates that only the employer, the Eligible Individual, and the Eligible Individual s family members may contribute to an Eligible Individual s HSA; however, Q/A-28 of Notice supersedes Q/A-11 of Notice Code Section 223(d)(1)(A)(i); see also Notice Q/A The 2003 Act amended Code Section 125 to add Section 125(d)(2)(D), which allows HSAs to be offered under the cafeteria plan despite the fact that amounts contributed during a year could be used in subsequent years. 34 Notice Q/A Code Section 223(f)(5)(A); see also Notice Q/A Notice Q/A Notice Q/A Notice Q/A Notice Q/A Notice Internal Revenue Code Section 223(b). 42 Code Section 223(d)(1) indicates that trustee/custodians cannot accept more than the Statutory Maximum Annual Contribution for family coverage plus the annual additional contribution amount. See also Notice Q/A Notice Q/A Code Section 3231(11), 3306(18); and 3401(22), added by the Medicare 76

78 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL Prescription Drug Improvement and Modernization Act of Notice Q/A Code Section 223(f)(2); see also Notice Q/A Notice , Q/A-34; Treas. Reg See Treas. Reg ; Notice , Q/A See Code Section 4980E(a), (b), and (d)(1) and (d)(2). Note that Code Section 4980E applies to an employer s Archer MSA contributions. Code Section 4980G applies to an employer s HSA contributions; however, Code Section 4980G prescribes the same rules applicable to Archer MSAs by reference to Code Section 4980E. 50 Treas. Reg G-3, Q/A Treas. Reg G-3, Q/A-6 52 Treas. Reg G-3, Q/A Treas. Reg G-1, Q/A Treas. Reg G-2, Q/A-2. IRS Notice , I.R.B. 196, Q/A Treas. Reg G-1, Q/A Treas. Reg G-4, Q/A Treas. Reg G-5, Q/A-1; See also, IRS Notice , I.R.B. 196, Q/A-47 and Q/A-49,. See also IRS Notice , I.R.B. 269, Q/A Treas. Reg G-5, Q/A-2. See also, IRS Notice , I.R.B. 196, Q/A Prop. Treas. Reg G-4, Q/A Prop. Treas. Reg G-4, Q/A Prop. Treas. Reg G-5, Q/A Code Section 223(f)(1); see also Notice Q/A Code Section 223(d)(2)(A); see also Notice Q/A Code Section 223(d)(2)(B) and (C); see also Notice Q/A Code Section 223(d)(2)(C). 66 Notice Q/A As this article goes to press, Congress is considering legislation (the Taxpayer Assistance and Simplification Act of 2008 (H.R. 5719)) that would impose a medical claims substantiation requirement on HSA trustees/custodians. 68 Notice Q/A Notice Q/A Notice Q/A Notice Q/A Internal Revenue Code Section 223(f)(4). 73 Code Section 223(f)(4)(B) and (C). 77

79 BANKING LAW JOURNAL 74 Q/A FAB , Q/A Q/A Q/A FAB , Q/A Q/A FAB , Q/A Q/A Q/A Code Section 408(e)(2)(A). 84 Code Section 408(e)(2)(B). 85 Code Section 223(e)(2). 86 See Notice , Q/A Notice , Q/A FAB , Q/A Code Section 4975(c). 90 ERISA Sec. 406(b)(2). 91 Code Section 4975(e)(1)(E). 92 Zabolotny v. Commissioner, 97 T.C Treas. Reg (a)(1). 94 Treas. Reg (e)(2). 95 Code Section 4975(d)(4). 96 Code Section 4975(d)(8) 97 Code Section 4975(d)(6). 98 Code Section 4975(d)(7). 99 FAB , Q/A-9; the DOL indicated that the class exemptions available to IRA account holders did not apply to HSA Account Holders. 100 See e.g. DOL Advisory Opinion 89-12A; PTE FAB , Q/A DOL Advisory Opinion A. 103 DOL Adv. Op A. 104 FAB , Q/A Code Section 4975(c)(6). 106 Code Section 4975(f)(4). 107 Treas. Reg (e)-1(b)(2)(ii). 108 Code Section 4975(f)(5). 109 See Kadivar v. Commissioner, T.C. Memo For 2008, the distribution code for normal distributions is 1. Also, 1 is the distribution code for any distributions that don t fit into any of the other distribu- 78

80 HEALTH SAVINGS ACCOUNTS: A COMPLIANCE MANUAL tion codes. 111 For 2008, the distribution code for deemed distributions to the estate is 4 and deemed distributions to non-spouse beneficiaries is See also Notice , Q/A. 67, For 2008, the prohibited transaction distribution code is Code Section 223(f)(3); Code Section 4973(g); Notice , Q/A For 2006, the excess contribution distribution code is 2. Interestingly, this is one of the few situations there may be more than one distribution code for the distributions made during the year. Trustee/Custodians may be required to file two separate 1099-SAs; one for normal distributions and another for excess contribution distributions. 116 See Notice , Q/A Code Section 223(d)(1)(A)(ii); Notice , Q/A Notice , Q/A-37, Notice Note that none of Joe s expenses incurred before the HSA was established are eligible for tax free reimbursement from the HSA. That being said, Joe is eligible to make a contribution for months prior to the month he establishes the HSA if he was otherwise eligible or under the Pro-rata Exception Rule established by the 2006 Act and discussed herein. 121 Code Section 408(i); see also Treas. Reg See instructions to Form W-2 and W Taxable employer contributions to an employee s HSA must be reported as wages on the employee s W-2 in Box 1, 2 and 5 and the employer must also file a Form 940. Most employer contributions will be tax free under Code Section 106 unless the employer had reason to believe that the contributions would not be excludable from income at the time they were made. This includes employee pretax salary reductions as well. 124 See Notice , Q/A See Prop. Treas. Reg , Q/A Notice , Q/A See 2005 Instructions for Forms W-2 and W See Instructions for Forms W-2 and W Notice , Q/A Notice , Q/A Notice , Q/A-63 clarified that a husband and wife cannot have a joint HSA; however, a spouse s expenses are eligible for tax free reimbursement from the other spouse s HSA. 79