SUMMARY OF QUALIFIED SMALL EMPLOYER HRAS

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1 SUMMARY OF QUALIFIED SMALL EMPLOYER HRAS On December 7, 2016, Congress passed the 21st Century Cures Act ("Act"), which President Obama is expected to sign. The Act permits small employers to adopt standalone health reimbursement arrangements ("HRAs") without incurring excise taxes under the Affordable Care Act ("ACA"). This is a very preliminary analysis. The Act has not yet been signed into law, and no guidance interpreting the Act is yet available. This summary is not intended to provide legal advice. Background Many small employers have historically paid the premiums for the health plan coverage that their employees purchased on the market or on a state based exchange ("Exchange") on a pre-tax basis. Some small employers also reimbursed some of the out-of-pocket medical expenses, such as deductibles or co-pays, for their employees on a pre-tax basis. This type of reimbursement arrangement is referred to as a "health reimbursement arrangement" or "HRA" and has been a very common, long-standing practice for small employers. The Internal Revenue Service ("IRS") issued a series of notices beginning in 2013 concluding that these types of stand-alone HRAs 1 are group health plans that fail to comply with the applicable market reforms under the ACA. Since they did not (and could not) comply with the ACA, employers adopting a stand-alone HRA were subject to an excise tax of $100 per day ($36,500 a year) per affected participant. In Notice , the IRS issued transition relief from these excise taxes for small employers through June 30, Significantly, employers with only a single full-time employee could continue to adopt a stand-alone HRA for that employee, under an exception to the group health plan rules for plans that have only a single participant. 2 For example, a church whose minister is the only full-time employee can reimburse the minister's premiums for coverage purchased in the individual market or the Exchange on a pre-tax basis without incurring excise taxes. This same exception also applies to "retiree-only" stand-alone HRAs, since they do not cover any employees. 1 Stand-alone HRAs are HRAs that are not integrated with an employer sponsored group health plan. 2 Although the exception provides only that the plan cannot cover more than one participant, an employer could only have one full-time employee in order to take advantage of this exception and not violate the nondiscrimination rules applicable to group health plans. 1

2 Summary of Act The Act creates a statutory exception to the IRS' prior guidance by excluding a "qualified small employer HRA" from the definition of group health plan. 3 The following rules apply: 1. Eligible Employers. Only eligible employers can establish a qualified small employer HRA. An eligible employer must meet the following two criteria: a. The employer cannot be a large employer for purposes of the ACA employer mandate in other words, the employer must have fewer than 50 full-time employees or full-time employee equivalents. b. The employer cannot offer a group health plan to any of its employees. i. There are many types of group health plans that are excepted from the ACA mandates and other rules that apply to group health plans. These include limited scope dental and vision plans and employee assistance plans that provide insignificant medical benefits. Without more guidance, it is not clear whether an eligible employer could offer these types of group health plans to its employees. ii. An employer cannot offer a health flexible spending account. iii. A health savings account ("HSA") is not a group health plan, so an employer can offer a HSA Eligible Employees. The HRA must be provided on the same terms to all eligible employees of the employer. An eligible employee includes all employees of the employer, except: a. employees who have not completed 90 days of service, b. employees who have not attained age 25, c. part-time or seasonal employees, d. employees covered by a collective bargaining agreement, and e. nonresident aliens with no U.S. source income. 3. Employer Funded. The HRA must be funded solely by the employer. 4. Substantiated Qualified Medical Expenses. The HRA provides, after the employee provides proof of coverage, for the payment or reimbursement of the 3 The only exception to this exclusion is that qualified small employer HRAs are taken into account for purposes of the "Cadillac tax" that takes effect on January 1, To be eligible to participate in a HSA, an individual must be covered under a high deductible health plan ("HDHP"). An eligible employer could not offer the HDHP, since it is a group health plan. Accordingly, an employee would have to secure HDHP coverage through a spouse, the individual market, or the Exchange in order to participate in the employer's HSA. 2

3 expenses of the employee or of the employee's family members of qualified medical expenses as defined in Section 213(d) of the Internal Revenue Code. 5 a. Qualified medical expenses include the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners. They include the costs of equipment, supplies, and diagnostic devices needed for these purposes. b. Qualified medical expenses must be primarily to alleviate or prevent a physical or mental defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation. c. Qualified medical expenses include the premiums for health insurance that covers the expenses of medical care, and the amounts paid for transportation to get medical care. Qualified medical expenses also include amounts paid for qualified long-term care services and limited amounts paid for any qualified long-term care insurance contract. 5. Permitted Benefit. The maximum amount of the payment or reimbursement that an employer provides under the HRA is called the "permitted benefit." a. The amount of the permitted benefit for any year cannot exceed $4,950 for employee-only HRAs or $10,000 for an HRA that covers the employee plus one or more family members. 6 Since the payment or reimbursement is limited to these dollar amounts for a year, it is not clear whether any of this amount could roll over to the following year. b. The permitted benefit under the HRA may vary in accordance with the variation in the cost of insurance coverage in the relevant individual health insurance market due to: i. the age of the eligible employee or his or her family members, as applicable, or ii. the eligible employee's number of family members. 6. Tax Impact. The permitted benefits provided to an eligible employee under the HRA for qualified medical expenses will not be included in his or her taxable income, unless the eligible employee does not have "minimum essential coverage" for that month. Minimum essential coverage is any health care coverage that satisfies the individual coverage mandate. 7. Written Notice. The employer must provide a written notice to each eligible employee at least 90 days before the beginning of the year that states the following: 5 See IRS Publication 502 for more information. 6 These limits are indexed for cost of living increases for years after If an employee is covered by a qualified small employer HRA for less than 12 months, these limits are pro-rated for the months of coverage. 3

4 a. The amount of the employee's permitted benefit under the HRA for the year, b. A statement that the eligible employee should provide the amount of his or her permitted benefit to the Exchange if the employee is applying for subsidies, and c. A statement that if the employee is not covered under minimum essential coverage for any month, the employee may be subject to an individual penalty and reimbursements under the HRA may be included in gross income. Employers who fail to provide timely written notices are subject to a penalty. However, for 2016, there is a transition rule if the notice is provided within 90 days after the enactment date of the Act (the date signed by the President). 8. Exchange Subsidies. An eligible employee participating in a qualified small employer HRA can purchase individual coverage on an Exchange, but may not be eligible for a subsidy. a. If an eligible employee receives "affordable" individual health insurance coverage under a qualified small employer HRA, then the employee will not be eligible for a subsidy on the Exchange. b. If the coverage the employee receives under a qualified small employer HRA is not "affordable," then the subsidy for which the employee is eligible is reduced by the permitted benefit. c. A qualified small employer HRA is treated as providing affordable coverage for a month if i. the premium amount that would be paid by the employee for such month for self-only coverage under the second lowest cost silver plan offered in the relevant individual health insurance market less ii. 1/12 of the employee's permitted benefit under the HRA iii. does not exceed 1/12 of 9.66% 7 of the employee's household income % applies for 2017, and is indexed for future years. 8 If the eligible employee is covered under the qualified small employer HRA for less than 12 months, substitute the number of months the HRA was provided for the 12 in this calculation. 4

5 EXAMPLE: Assume an eligible employer offers a qualified small employer HRA to eligible employees with a permitted benefit equal to $3,000. The cost for self-only coverage under the second lowest cost silver plan offered in the Indiana Exchange is $286 for An eligible employee has household income equal to $35,000 and is covered under the HRA all year. $286 ($3,000 / 12 = $250) = $16 per month 1/12 x 9.66% x $35,000 = $ per month $16 < $ The coverage is affordable, and the eligible employee is not eligible for a subsidy on the Exchange. d. The eligible employee is required to provide the amount of his or her permitted benefit when applying for coverage on the Exchange. Under transition relief, if an application for enrollment in the Exchange is made before April 1, 2017, this requirement will be treated as met if provided within 30 days after the eligible employee receives the employer's written notice. 9. W-2 Reporting. The employer is required to report the permitted benefit under the qualified small employer HRA on the Form W-2s for each eligible employee beginning for the 2017 calendar year. Currently, transition relief exempts employers filing fewer than 250 Form W-2 from reporting the cost of coverage on the Form W-2, as well as exempts HRAs. It is not clear whether this transition relief will also extend to the qualified small employer HRA. Taking Advantage of the Qualified Small Employer HRA Eligible employers have already put into place arrangements for It may be too late to change those arrangements for 2017 given existing contractual commitments to employees. However, in some cases, employers may be able to restructure their arrangements in order to take advantage of the qualified small employer HRA. If an eligible employee has a single full-time employee and relied on the exception for plans that cover only one employee, then no action is needed. This is the most advantageous structure available. Larger employers may have adopted a strategy of paying additional taxable income to their employees, which the employees could use for any purpose. This additional income is frequently referred to as a "health insurance stipend," because it was intended to 9 See Affordable-Care-Acts-Health-Insurance- marketplaces/ for the second lowest cost silver plans for 2017 in each state. 5

6 replace the contribution that the employer historically provided toward health insurance premiums, grossed up to take into account that the income is taxable. HEALTH CARE STIPEND EXAMPLE: For 2017, an eligible employer determined to pay a health care stipend as additional taxable income to employees in the following amounts: $500 per month for an employees with no dependents, grossed up 20% = $7,200 per year $1,000 per month for an employee with one dependent, grossed up 20% = $14,400 per year $1,500 per month for an employee with a family, grossed up 20% = $21,600 per year The employee could use the health care stipend to purchase insurance on the individual market or an Exchange, or could use it for any other purpose. An employee who purchased coverage on an Exchange could qualify for a subsidy. RESTRUCTURING THE HEALTH CARE STIPEND. The eligible employer could restructure this arrangement for 2017 (subject to contractual commitments) to provide the following permitted benefits through a qualified small employer HRA: 1. The qualified small employer HRA could provide the following permitted benefits: $ per month for an employee only HRA = $4,950 per year $ per month for an employee plus family HRA = $10,000 per year The permitted benefit would need to be made available to all eligible employees. Employees would need to submit proof of coverage to the employer before the employer can reimburse medical expenses or premiums. 2. The remainder of the health care stipend for the employee with no dependents ($2,250), the employee with one dependent ($4,400), and the employee with a family ($11,600), would continue to be paid as taxable income. Alternatively, since some portion of the health care stipend is now being paid on a pre-tax basis, the employer could reduce the total stipend to take into account a reduced gross-up. 3. The employer would need to provide a written notice to eligible employees within 90 days of the Act's enactment. 4. Employees who receive coverage under the Exchange must provide the amount of the permitted benefit to the Exchange within 30 days of receipt of the employer's written notice. Because the coverage in this example is affordable, eligible employees will not be eligible for subsidies on the Exchange. 6

7 5. Any employment agreements and handbooks would need to be revised to reflect the new health care stipend amounts and the permitted benefit under the qualified small employer HRA. Some considerations in making this change for 2017 are as follows: Some employees may have spousal coverage, and were intending to use the health care stipend as additional taxable income. Because of the qualified small employer HRA rules, all eligible employees would have to be provided the HRA, including employees who might prefer the taxable income. These employees can pay for their out-of-pocket costs from their spousal coverage or other qualified medical expenses that are not covered under their spousal coverage from the HRA, but the amount of the permitted benefit may exceed these types of expenses. 10 Some employees may have secured coverage on an Exchange and qualified for a subsidy. Under the existing arrangement, they would receive the full amount of the taxable health insurance stipend, grossed-up, and qualify for subsidized coverage. Since their premium costs are subsidized, they will be able to keep more of the stipend as additional income. However, under the restructured arrangement, they will either lose their Exchange subsidy (if the permitted benefit provides affordable coverage) or their Exchange subsidy will be reduced (if the permitted benefit does not provide affordable coverage). This means that they would have to pay a higher premium for their coverage, and there is less available either under the HRA or as a taxable health insurance stipend, as applicable. The employer is required to substantiate expenses under the qualified small employer HRA, to report the cost of the permitted benefit on Form W-2s (subject to possible transition relief), and to provide a timely written notice to eligible employees, so there is additional administration involved with this type of HRA. On the other hand, a qualified small employer HRA provides a significant tax benefit for the employer and employee, which may allow an employer to provide a more substantial benefit than it could otherwise. The considerations outlined above are no different than those that employees face when employers provide affordable health care coverage, they are simply more salient here given the transition from a health insurance subsidy to a qualified small employer HRA. Going forward, we expect that the qualified small employer HRA will likely be the preferred approach for eligible employers. Effective Date The Act is effective for years beginning after December 31, Accordingly, an eligible employer can establish a qualified small employer HRA effective January 1, The employee portion of the premium for the spouse's coverage could not be paid through the qualified small employer HRA, since it is already paid pre-tax through that employer's cafeteria plan. 7

8 In addition, the Act extends the transition relief for small employers under Notice through the end of the plan year beginning on or before December 31, Accordingly, small employers will not be subject to excise taxes for having offered a stand-alone HRA prior to January 1, 2017 (for calendar year plans). Impact on Existing Exceptions The Act does not change the existing exception for employers who have only one fulltime employee for whom they reimburse premiums on a pre-tax basis or who reimburse premiums or medical expenses for retirees only. An employer who can meet this exception can continue these arrangements without satisfying the requirements for a qualified small employer HRA. I\