QUESTION: Our company would like to establish a health reimbursement account (HRA) when we switch to higher deductible health coverage. Will our owners be able to participate in that HRA?
ANSWER: The answer depends on several factors, including how your company is organized and the amount of the company owned by each working owner. Tax-free benefits under an HRA can be provided only to current and former employees (including retirees), and their spouses, covered tax dependents, and children who have not attained age 27 by the end of the tax year. Owners who are “self-employed individuals” within the meaning of Code §401(c) are not considered employees for this purpose and may not participate in an HRA on a tax-favored basis. Generally, a self-employed individual is an individual who has net earnings from self-employment as defined in Code §1402(a), taking into account only earnings from a trade or business in which the “personal services of the taxpayer are a material income-producing factor.” Ineligible owners include partners, sole proprietors, and more-than-2% shareholders in a Subchapter S corporation. Stock ownership by employees of a Subchapter C corporation does not preclude their tax-favored HRA participation.
The ownership attribution rules in Code § 318 apply when determining who is a more-than-2% shareholder of a Subchapter S corporation, so any employee who is the spouse, child, parent, or grandparent of a more-than-2% shareholder of a Subchapter S corporation would also be unable to participate in the S corporation’s HRA on a tax-favored basis. Disqualified individuals (whether due to direct or attributed ownership) could, however, be the beneficiary of a qualifying participant’s HRA coverage if they are the qualifying participant’s spouse, tax dependent, or child under age 27.
Although the IRS has not clearly addressed whether self-employed individuals may participate in an HRA if the company treats the HRA coverage as a taxable benefit, informal IRS comments suggest that participation on a taxable basis is not allowed (even though the IRS has permitted such participation for non-tax dependent domestic partners).
While self-employed individuals cannot participate in HRAs, they can have HSAs, although they cannot receive tax-free contributions to their HSAs through a cafeteria plan. This relative advantage for HSAs has led some employers to favor HSA programs over HRAs (see our Checkpoint article). HRAs have other advantages for employers, though, including more control over how amounts are spent and typically lower costs relative to the nominal amount of benefits provided. (While the full HSA contribution must be funded with cash, HRAs typically are notional accounts that need only be funded when participants incur expenses, and not all participants will incur expenses up to the limit established by the employer.) Thus, the decision will seldom be made based on the participation rules alone. For more information, see EBIA’s Consumer-Driven Health Care manual at Sections XXII.B (“Who Can Be Provided Tax-Free Benefits?”) and XXI.D (“HRAs Are Not Subject to HSA Rules”).
Contributing Editors: EBIA Staff.