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 John.Hickman@alston.com, Ashley.Gillihan@alston.com, and Joseph.Yesutis@alston.com, 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