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Guest Article

Deloitte logo

(From the March 19, 2007 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

IRS Reiterates Approval of Funding HRAs with Unused Vacation and Sick Leave

A recent IRS private letter ruling (PLR) confirms that employers can fund health reimbursement arrangements (HRAs) with employees' unused vacation and sick leave under certain circumstances. PLR 200708006 (February 23, 2007). The PLR applies the principles of Revenue Ruling 2005-24, 2005-1 C.B. 892, which held employers can use sick and vacation conversion arrangements to fund HRAs so long as employees do not have the option to take the converted benefits in cash. The PLR is a reminder that HRAs continue to be a viable alternative to health savings accounts (HSAs), even though HSAs get more attention from policymakers, regulators and the popular press.


At issue in the PLR is a proposed HRA plan that will be available to an employer's eligible retiring employees, their spouses and dependents. Eligibility will be limited to employees who regularly work at least 20 hours per week and who meet a 30 day waiting period. All retiring employees who meet the eligibility criteria will automatically be covered by the HRA plan.

Only the employer will be permitted to make contributions to the HRAs. In addition to discretionary employer contributions, the HRAs will be funded with sick leave and vacation conversion arrangements. The unused vacation and sick leave eligible for conversion will be divided into three categories: (1) vacation and sick leave accrued before the plan's effective date; (2) annual excess vacation and sick leave that would otherwise be forfeited or paid out at year end; and (3) accumulated and unused vacation and sick leave upon retirement. The employer will have sole discretion to determine the amount or percentage of each category of unused vacation and sick leave that will be converted to HRA contributions.

The HRAs will be available only to pay medical expenses incurred by covered retirees, their spouses or dependents, and for no other purpose. When a covered retiree dies, his or her surviving spouse and dependents can continue using the HRA to pay medical expenses. Any HRA balances remaining after the covered employee and his or her spouse and dependents have died will be forfeited.

May Employer Fund HRA With Unused Vacation and Sick Leave?

The question is whether the proposed HRA plan will be eligible for the IRC § 106(a) gross income exclusion for employer-provided health benefits, and the IRC § 105(b) gross income exclusion for benefit payments from employer-provided health plans. The HRA will qualify for these exclusions only if it:

  1. is funded solely by the employer and not pursuant to a salary reduction election or otherwise under an IRC § 125 cafeteria plan;
  2. reimburses covered employees or retirees only for IRC § 213(d) medical expenses incurred by the employee or retiree and his or her spouse and dependents; and
  3. provides reimbursements up to a maximum dollar amount, and allows for the carryover of unused balances from one coverage period to the next.

More particularly, the question is whether the sick leave and vacation conversion arrangement violates the requirement that HRAs be funded solely by employers, and not by any employee salary reduction election. The PLR concludes the HRA plan does not violate this requirement (or any other applicable HRA requirement), presumably because employees and retirees do not have any discretion to decide if these unused benefits will be converted to cash, contributed to their HRAs, or used to pay for other benefits. These decisions will be made exclusively by the employer.

A different result would have followed if, for example, employees or retirees were given the option to take unused vacation or sick leave in cash or have an equivalent amount contributed to the HRA.

Deloitte logoThe 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.

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.
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