Guest Article

(From the February 26, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Details of IRS Guidance on Qualified HSA Distributions -- Action May Be Needed by March 15

The IRS on February 15, 2007 issued Notice 2007-22 to provide guidance on "qualified HAS distributions" from health reimbursement arrangements (HRAs) and health flexible spending arrangements (FSAs). Qualified HSA distributions are tax-favored rollovers from HRAs and health FSAs to health savings accounts (HSAs), similar to direct rollovers from 401(k) plans to Individual Retirement Accounts (IRAs). But the rules for making qualified HSA distributions are more difficult to navigate than the rules for retirement plan rollovers. Fortunately, Notice 2007-22 provides a roadmap to follow.

A more detailed analysis follows, but the quick and dirty is that all of the following conditions must be satisfied for qualified HSA distributions to work:

There is also special transition relief for qualified HSA distributions relating to 2006 balances. All the same rules apply, except:

Employers that decide to offer qualified HSA distributions should closely study Notice 2007-22, which includes extensive and detailed examples of how these distributions work. The Notice is available on the IRS's Web site, at www.irs.gov/pub/irs-drop/n-07-22.pdf. Additional guidance on qualified HSA distributions is expected.

Overview of Qualified HSA Distributions

The Health Opportunity Patient Empowerment Act ("Act") creates a window during which employers can permit employees to elect "qualified HSA distributions" from their health FSAs or HRAs, beginning December 20, 2006 and ending December 31, 2011. A "qualified HAS distribution" is a one-time distribution from a health FSA or HRA that the employer contributes directly to the trustee of the employee's HSA. The maximum amount of the distribution is the balance of the health FSA or HRA on September 21, 2006 or the date of distribution, whichever is less. Consequently, an employee may not elect a qualified HSA distribution from any health FSA or HRA that did not cover the employee as of September 21, 2006.

A qualified HSA distribution is a direct rollover from a health FSA or HRA to an HSA, similar to a direct rollover from a 401(k) plan to an Individual Retirement Account (IRA). Like direct rollovers from 401(k) plans to IRAs, qualified HSA distributions do not reduce the amount employees can contribute to their HSAs for a year. Also, qualified HSA distributions receive favorable tax treatment. However, this favorable tax treatment is available only if the employee is an "eligible individual" continuously during a twelve-month "testing period." The testing period begins with the month in which the employer contributes the qualified HSA distribution to the employee's HSA and ends on the last day of the twelfth month following such month.

The consequences of failing to be an eligible individual at any time during the testing period are severe for the employee. Specifically, the qualified HSA distribution amount is included in the employee's gross income and subjected to a ten percent penalty tax. But the employee does not have to withdraw the qualified HSA contribution. In fact, if the employee does withdraw the qualified HSA distribution and does not use it to pay medical expenses, the amount withdrawn is included in the employee's gross income and might be subjected to a ten percent penalty tax.

Employers choosing to offer qualified HSA distributions to their employees must amend their health FSAs or HRAs, effective by the last day of the plan year, to permit such distributions. Also, pursuant to the employer comparable contribution requirement, the qualified HAS distribution option must be available to all eligible individuals who are covered by the employer's high-deductible health plans (HDHPs).

Interaction With Other Rules

The rules for qualified HSA distributions seem fairly straightforward. But coordinating the requirement that an employee be an "eligible individual" immediately after a qualified HAS distribution with certain other rules relating to HSAs, health FSAs and HRAs can be tricky. These "other" rules, as highlighted in Notice 2007-22, include the following:

"HSA-Compatible" HRAs and Health FSAs

Some of these potential coordination problems go away if the qualified HSA distribution is being made from "HSA-compatible" HRAs or health FSAs. The reason is that employees can be covered by these HRAs or health FSAs and still be eligible individuals. These "HSAcompatible" HRAs and health FSAs are as follows:

Regarding Health FSA and HRA Balances

Before turning to specific issues relating to qualified HSA distributions, it is important to note the rules for calculating the balance in a health FSA or HRA at any given point in time. The health FSA or HRA balance is relevant to determining whether a qualified HSA distribution is permitted and the amount of any qualified HSA distribution that can be made.

According to Notice 2007-22, health FSA and HRA balances are to be determined on a cash basis for all purposes. This means the balance on any date is calculated without regard to any expenses that have been incurred but not yet reimbursed -- including pending claims, claims submitted, claims received, and/or claims under review but not yet paid. Also, the uniform coverage rule must be applied when determining the balance in any health FSA; in other words, the balance is the maximum reimbursement available for the plan year less any reimbursements to date.

Qualified HSA Distributions from General Purpose HRAs

Now, consider an example of how these rules are applied. Assume a qualified HSA distribution from a general purpose HRA on March 2. (The date of a qualified HSA distribution is the date the employer actually transfers the money to the employee's HSA.) If the employee establishes HDHP coverage on the same day, s/he cannot be an eligible individual until April 1. As a result, the employee is not an eligible individual immediately after the qualified HSA distribution. Thus, the qualified HSA distribution amount is included in the employee's gross income and assessed a ten percent penalty tax.

What if the same employee instead established HDHP coverage on February 28? That takes care of one problem, but the employee still is not an eligible individual immediately after the qualified HSA distribution. The reason is the general purpose HSA coverage continues beyond March 2, even if the qualified HSA distribution reduced the HRA balance to zero. So again, the qualified HSA distribution amount is included in the employee's gross income and assessed a ten percent penalty tax.

In order to address these problems, Notice 2007-22 advises qualified HSA distributions from general purpose HRAs can take place only at the end of the HRA plan year. According to the Notice, an employee with a zero balance in a general purpose HRA on the last day of the HRA plan year can be an eligible individual as of the first day of the next HRA plan year if --

Qualified HSA Distributions from General Purpose Health FSAs

Qualified HSA distributions from general purpose health FSAs face the same obstacles as those from general purpose HRAs, plus one more: any unused balances in a health FSA at the end of the plan year are forfeited pursuant to the use-it-or-lose-it rule. So if a qualified HAS distribution is made from a health FSA before the plan year ends, the employee will fail to be an eligible individual immediately after the distribution because the health FSA coverage continues. But if the qualified HSA distribution is delayed until after the plan year ends, the health FSA balance is forfeited and there is nothing left to distribute!

According to Notice 2007-22, as a practical matter only general purpose health FSAs with grace periods can successfully make qualified HSA distributions. The grace period is a period of up to 2.5 months following the end of a health FSA plan year that employees can incur medical expenses and pay for them using health FSA balances from the previous plan year. The IRS originally took the position that health FSA participants could not be eligible individuals during the grace period even if their health FSA balances were zero as of the end of the plan year. But the Health Opportunity and Patient Empowerment Act amends the HSA rules to provide a health FSA participant can be an eligible individual during the grace period if:

Specific Guidance on Qualified HSA Distributions from General Purpose HRAs and General Purpose Health FSAs

Notice 2007-22 gives specific, step-by-step instructions on making qualified HSA distributions from general purpose HRAs and general purpose health FSAs. Employers that want to offer qualified HSA distributions to employees should follow these steps exactly to avoid adverse tax consequences for their employees.

According to the Notice, an employee with a balance in a general purpose health FSA with a grace period or general purpose HRA at the end of a health FSA or HRA plan year (plan year) is treated as an eligible individual for HSA purposes as of the first day of the first month in the immediately following plan year that the individual has HDHP coverage on the first day of the month if:

Special Transition Rule

Because the qualified HSA distribution rules are effective beginning December 20, 2006, some employers may want to make qualified HSA distributions from general purpose HRAs or general purpose health FSAs for the plan year ended December 31, 2006. However, the rules detailed above do not allow for that because it is too late to amend the HRA or health FSA by the end of the plan year. Thus, the Notice also provides a special transition rule for qualified HAS distributions completed before March 15, 2007.

According to Notice 2007-22, an employee with a balance in a general purpose health FSA or general purpose HRA after December 31, 2006 is treated as an eligible individual for HAS purposes as of the first day of the first month in 2007 that the employee has HDHP coverage on the first day of the month if:

What About HSA-Compatible HRAs and Health FSAs?

Qualified HSA distributions from an HSA-compatible HRA or health FSA can happen at any time during the HRA or health FSA plan year because the ongoing HRA or health FSA coverage will not prevent the employee from being an eligible individual. However, when scheduling qualified HSA distributions from HSA-compatible HRAs or health FSAs employers still must be mindful of the rules for when eligible individual status begins.

Employer Reporting of Qualified HSA Distributions

Finally, Notice 2007-22 clarifies employers' reporting obligations relating to qualified HAS distributions. The Notice states employers should not report qualified HSA distributions in box 12 of Form W-2. Additionally, employers are not responsible for reporting whether employees remain eligible individuals during the testing period. However, employers are required to report qualified HSA distributions as rollover contributions to the HSA trustee, and the HSA trustee must report the qualified HSA distribution as a rollover contribution on Form 5498-SA.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Taina Edlund 202.879.4956, Laura Edwards 202.879.4981, Mike Haberman 202.879.4963, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Laura Morrison 202.879-5653, Martha Priddy Patterson 202.879.5634, Tom Pevarnik 202.879.5314, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2007, Deloitte.