February 1, 2007
IRS Rules on Public Sector Post Employment HRA
Private Letter Ruling 200704005 (released January 26, 2007) provides valuable guidance1 to public sector employers with, or considering, reimbursement account programs for the payment of post employment medical expenses (a/k/a post employment HRAs).
The PLR addresses a proposed2 plan design under which employees would be able to make one-time, irrevocable elections to contribute accrued leave and/or regular compensation to a Health Reimbursement Arrangement (“HRA”). Employees would be required to make the election within 30 days of initial eligibility. If they did not elect to participate upon initial eligibility, employees could also make the election on an annual basis with respect to the next year.
Comment: This was a fairly common design feature prior to the HRA guidance issued in June of 2002.
The IRS rejected the proposed plan design because these contributions would be employee contributions resulting from the exercise of employee choice. Such contributions would not be considered employer contributions, in contrast to mandatory contributions of accrued leave and mandatory contributions of compensation. Employer contributions (including mandatory contributions of accrued leave) to an HRA are excludable from the employee’s gross income under Section 106 of the Internal Revenue Code. However, employee elective contributions are not excludable.
The IRS analysis extends beyond mere constructive receipt rules. In general, an individual can avoid constructively receiving income if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions (i.e., distant choice and irrevocable elections). However, in this ruling, the elections under the proposed HRA plan had the distant choice and irrevocability features. The IRS appears to have ruled that, even if constructive receipt is avoided, employee elective contributions to an HRA are includable in the employee’s gross income. The IRS emphasized that an HRA must be funded “solely by the employer and not pursuant to a salary reduction election or otherwise under a Section 125 cafeteria plan.” Therefore, these elective contributions cannot be made to an HRA and excluded from income under Section 106.
What does that mean? A program cannot allow employees to make elective contributions to the plan, even if the program requires distant choice and/or one time irrevocable employee elections. Amounts contributed in that fashion would be taxable income to the employees. They would not be employer contributions and could not be contributed to an HRA.
Looking beyond the PLR. Because the PLR addressed a proposed plan design, the IRS did not need to address the issue of already contributed monies. So we do not know the full tax impact of employee elective contributions. For example, does the program have to distribute those funds to preserve its status as an HRA? If so, what happens to the earnings on the distributed funds? Can they stay in the HRA? Are they forfeited? Are they distributed and taxed?
Comment: It is our understanding payroll audits of public sector plan sponsors are occurring across the nation with respect to these types of contributions to HRAs. So, we may know the answers to the questions left open by the PLR shortly.
Action Items. Employers with reimbursement accounts for payment of post employment medical expenses should review the programs for employee choice (not merely constructive receipt) features, including:
- elections regarding pay reduction;
- elections regarding converting unused leave into HRA contributions;
- distant choice elections; and
- “opt in” approaches (e.g., irrevocable elections to participate).
If you need assistance in reviewing your plan, please contact our office.
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1The purpose of a PLR is to advise a taxpayer regarding the tax treatment an individual or entity can expect from the IRS in a particular set of circumstances. In other words, if a taxpayer has a tax issue with the IRS, the taxpayer can request the IRS to rule on that tax issue in advance. The PLR is specific and applicable to that tax situation and that taxpayer only. Moreover, PLRs of other taxpayers cannot be relied upon as precedent, and do not require the IRS to take a similar position when dealing with different taxpayers. Nevertheless, a PLR is helpful in determining the IRS’s position on a particular topic.
2Not in place and operating.
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The information contained in this ALERT is intended for general information purposes only and does not constitute legal advice relative to a specific situation.