Health savings accounts (HSAs) provide employers with a flexible tool for providing health benefits to employees. Employers and employees can vary their level of involvement in an HSA program to strive for an ideal balance both at the group level and the individual employee level.
The flexibility of HSA programs has led to rapid growth and acceptance of HSAs, but has also created misunderstandings for employers implementing HSA programs. Some employers assume that the individual nature of HSAs relieves the employer of all compliance burdens, while other employers assume they can exercise a greater amount of control over employees’ HSAs than is allowed.
This article focuses on the special rules that apply to employers implementing an HSA program and clarifies the responsibilities of the employer, employees, and the HSA custodian. [This article is updated and adapted from an article first published in Benefits Quarterly: Johnson, Whitney R., (2012, 3rd Quarter), HSA Programs for Groups: Employer Versus Employee Responsibilities, Benefits Quarterly, (Vol 28, pp. 43-51)].
Flexibility in level of employer involvement
Employers interested in HSAs face a variety of potential levels of involvement.
- Employer-provided HDHP or not: An employer may or may not offer a group High-Deductible Health Plan (HDHP). Employers are allowed to offer the HSA benefits described in this article to HSA-eligible employees even if the employer does not offer the corresponding health insurance.
- Employee-funded HSA: Employers are not required to help fund employees’ HSAs and may choose not to do so. In this option, the employee is on his/her own to open and fund the HSA. The employer could offer a direct deposit feature to the employees’ HSAs provided the employer properly reports the contribution as ordinary income on the employee’s Form W-2.
- Employee-funded HSA, pre-tax through payroll deferral: Employers can help employees fund their HSAs by allowing for HSA contributions pre-tax through payroll deferral. This requires that the employer adopt a Section 125 Cafeteria Plan with an HSA option.
- Employer pre-tax contributions: Employers may make direct contributions to their employees’ HSAs subject to the HSA comparability rules.
- Employer pre-tax contributions and pre-tax payroll deferral: Employers can combine an employer contribution with pre-tax payroll deferral to create the most powerful combination of HSA benefits for employees.
Pre-tax employer contributions trigger special rules
The IRS defines an “employer contribution” as a pre-tax employer contribution or a pre-tax employee payroll deferral and employers that make pre-tax HSA contributions trigger the special group HSA rules. HSAs are tax-driven accounts and basing the rules on the tax status is appropriate.
Accordingly, special HSA group level rules apply even if an employer has only one employee that receives a pre-tax HSA contribution. Conversely, an employer with many employees with HSAs is not subject to the HSA group rules provided the employer only allows after-tax payroll contributions into the HSAs or no contributions at all.
No employer pre-tax contribution eliminates special rules
Employers that offer no assistance for HSAs, or only offer after-tax HSA payroll deferrals, do not face any of the special rules that apply to group HSA plans. An employer in this position is capitalizing on the unique benefit of HSAs in health benefits law – that individuals can open and contribute to an HSA without employer involvement and still get a tax break. This allows for those employees that would benefit from an HSA to do so on their own. This approach works well for small businesses that are struggling to finance even a portion of the health insurance premium and are not equipped to expand employee benefits.
Given the low expense and administrative burden, a larger business should consider adding an HSA pre-tax payroll deferral option. Even very small employers are encouraged to offer this feature to employees because of the payroll tax savings. (Click or touch to enlarge chart.)
Employer HSA contributions bring tax benefits
Employers that allow pre-tax HSA contributions maximize the tax benefits for their employees and the business. The main tax benefit for most employees is income avoidance and employees get this benefit from personal HSA contributions (as a deduction from income) as well as employer contributions (as pre-tax). The additional tax savings from employer pre-tax contributions come from payroll taxes: Social Security (FICA), Medicare, Federal Unemployment Tax (FUTA), and possibly State Unemployment Tax (SUTA). Both employer-direct contributions and pre-tax payroll deferral HSA contributions avoid payroll taxes. The savings achieved by avoiding payroll taxes are worth the effort. FICA is 6.2 percent up to $118,500 (2015) on the employer side and another 6.2 percent for the employee side. Medicare is an additional 1.45 percent for both the employer and the employee on all income. The FUTA tax is relatively small and only the employer pays it (generally 0.8 percent on the first $7,000), but there may be savings for State Unemployment Taxes as well.
Section 125 Plan required for pre-tax payroll deferral
Employers that choose to allow employee pre-tax payroll deferrals into an HSA must establish a Section 125 plan (a plan that meets the requirements of Section 125 of the Internal Revenue Code). Section 125 plans, or Cafeteria Plans, are relatively easy to establish and generally do not require the employer to submit any paperwork to the IRS or an annual IRS Form 5500 filing. The “Cafeteria” name is appropriate because the plans generally offer a choice of tax-deferred benefits: accident and health insurance premiums, dependent care, adoption assistance, group-term life insurance and HSA contributions. Many employers already have a Section 125 plan because the plan is necessary in order to allow an employee to pay a portion of the health insurance premium pre-tax. In that case, the employer must confirm that the plan allows for HSA deferrals. If not, the plan provider can likely add the necessary language for a small fee.
A Section 125 plan is a written legal document that the employer signs, maintains and administers. By signing the document, the employer agrees to comply with the rules contained in the document regarding types of benefits allowed, treating employees fairly, and other IRS requirements. The maintenance of the document itself generally means updating the document periodically to comply with law changes as well as keeping the signed copy on file in case of an IRS audit. Administering the Section 125 requires some work.
For payroll deferral into an HSA through a Section 125 plan, the employer must reduce the employees’ pay by the amount of the deferral and contribute that money directly into the employees’ HSA. The employer may do this administration itself or it may use a payroll service or another type of third-party administrator. In any case, the cost of the Section 125 plan itself and the ongoing administration are generally small and offset, if not entirely eliminated, by employer savings through reduced payroll taxes.
Another administrative element is the collection of Section 125/HSA payroll deferral election forms from employees. Employers that have offered Section 125 plans prior to introducing an HSA program are familiar with this process. Unlike other Section 125 plan deferral elections which only allow annual changes, the law allows for changes to the HSA deferral election as frequently as monthly. Although frequent changes to the elections create a small administrative burden on the employer, the benefit to employees is significant.
The ability to change deferral elections allows employees to adjust mid-year to what the year’s expenses actually are versus what they planned. An employee that initially expected a low expense healthy year and elected only a small HSA payroll deferral can adjust when surprised by a large medical expense. Conversely, an employee that elected to defer a large amount into the HSA but later faces lower than anticipated medical expenses (or faces higher than anticipated non-medical expenses) can adjust their deferral downward. Employers are allowed, but not required, to accept prospective monthly changes to deferral elections. Prospective means that the change cannot take effect until the month following the change date.
Offering pre-tax HSA payroll deferral makes sense for most employers that provide an HSA-eligible health insurance program. The cost, compliance and administrative burdens are low compared to the tax benefits for the employer and the employees. Employers can obtain these same tax benefits without a Section 125 plan by giving HSA money to the employees rather than using employee payroll deferral; however, then the employer must meet the comparability rules.
Comparability testing for employer pre-tax contributions
The most complicated compliance issue facing employers adopting HSA plans is comparability testing. Congress created the concept of “comparability” to ensure that employer-provided HSA contributions are made on a fair basis across employee groups. Those familiar with 401k plan discrimination testing understand the nature of these types of rules and the accompanying complexity. The comparability rules are long, difficult, and sometimes counter-intuitive. Plus, the government imposes a severe 35 percent penalty for failure to comply. One positive attribute of the severity of the penalty is that most employers are aware of this rule.
The burden of meeting the comparability rules is more than offset by the tax advantages. Employers meeting the comparability rules can deduct the amount of the HSA contribution as a business expense (IRC § 106(d)). Neither the employer nor the employee has to pay payroll taxes on the contribution and the employee avoids federal income taxes and in most cases state income taxes.
Although the IRS regulation includes the term “comparability testing,” the term refers to ensuring that the contributions are comparable at the time made. There is no need to test later, except as it relates to new hires. This simplifies the rule as compared to other benefit plan testing that occurs after the end of the period when corrections are more difficult. Also, employers are not required to submit the results of the comparability testing to the government, except possibly as part of an IRS or other government agency audit.
The lengthy regulations lend themselves to a three-step process:
First – Does comparability testing apply? Employers should first question whether the rule applies. The rule only applies if an employer makes pre-tax contributions to an employee’s HSA outside of a Section 125 plan (i.e., when the employer gives money to employees’ HSAs).
Many employers choose not to contribute directly to their employees’ HSAs and instead only offer an HSA payroll deferral option to allow the employees to self-fund the HSA through a Section 125 plan. In this case, the comparability rules do not apply because the law provides an exception for HSA contributions made through a Section 125 plan. This is an important exception to the comparability rules and applies to all contributions made through a Section 125 plan. This exception allows for some planning opportunities where employers can contribute to the Section 125 plan rather than the HSA directly in order to avoid the comparability rules.
Second – Are employees properly categorized? Once the employer has determined that comparability does in fact apply, the next step is to determine the categories that must be treated comparably. The comparability rules do not require that everyone get comparable treatment, just comparable treatment for employees in the same category. The IRS provides clear guidance on the acceptable categories and does not allow for employers to create additional categories. The chart illustrates all of the acceptable categories (click or touch to enlarge chart).
The employees within the same category must be treated comparably. The categories are listed as one group versus another to illustrate that the rule allows employers to treat these groups differently. For example, an employer can treat part-time employees differently than full-time employees without worrying about any relationship between the two groups (e.g., an employer can give full-time people a generous HSA contribution and nothing to part-time).
There are two exceptions to this general rule. First, for non-highly compensated versus highly compensated employees, the comparability rules allow the groups to be treated differently so long as non-highly compensated employees get a larger HSA contribution than highly compensated employees. The second exception follows the same logic. Employers are allowed to make different size contributions to the sub-categories (self plus one, self plus two, and self plus three or more) within the family category as long as the contribution amount does not decrease as the family size increases.
A very common use of the ability to treat separate categories of employees differently is for employers to treat family HDHP covered employees differently than single HDHP covered employees. A couple of examples illustrate the power of the exception in planning and allowing the employer flexibility in how to operate the HSA program. (Click or touch to enlarge chart.)
- “Reward single employees” example: Tom’s Toys offers its employees a choice of family HDHP coverage and self-only HDHP coverage. Employees that select self-only HDHP coverage cost the company less money. To reflect the cost savings, Tom’s Toys decides to give each employee that selects self-only coverage a $200 per month contribution into an HSA. Tom’s Toys decides to make no HSA contribution for family covered employees. Even though the amounts are not the same, this meets comparability rules because single HDHP coverage and family HDHP coverage are two separate categories and the rules allow discrimination between categories.
- “Provide more for families” example: Assume the same facts as above, except Tom’s Toys changes management. The new management believes family HDHP covered employees need a larger HSA contribution because with more people covered by the insurance, they are more likely to need additional health care dollars. The new management changes the next year’s HSA contribution to $200 for each employee with family HDHP coverage and no HSA contribution for self-only covered employees. Although this approach is the exact opposite of the first example it also meets the comparability rules for the same reason.
No other categories are allowed. Employers often desire to favor management over non-management employees. This is not a permissible category and this rule prevents employers from making larger HSA contributions for management versus non-management. Employers may desire to allocate larger HSA contributions to older employees, possibly to reflect the larger catch-up contribution allowed for those aged fifty-five through sixty-five, but age is not a permissible category. The list of non-permissible categories is endless. The IRS states the only permissible categories.
Third – Are the contributions comparable? The final step is to ensure that the group is making comparable contributions to employees in the same category. Comparable contributions within a category means the employer must either contribute the same dollar amount or the same percentage of the deductible.
This step is generally simplified because many employers elect to give comparable employees the same dollar amount. Employers offering a choice of HDHP insurance plans may use the same percentage method instead of the same dollar amount.
- “Different deductibles” example: Tom’s Toys offers two HDHP plans: Plan A with a $2,500 deductible and Plan B with a $3,500 deductible. Tom’s Toys plans to make an HSA contribution for its employees and is considering making a $1,500 contribution to all employees in the same category or giving different amounts depending upon the deductible. Under the percentage of the deductible method, Tom’s Toys would give each employee 50 percent of the deductible so Plan A participants would receive a $1,250 HSA contribution and Plan B participants would receive $1,750. These choices meet the comparability rules.
Timing of contributions
Employers often misunderstand how timing of the contributions impacts comparability testing. The IRS provides three methods for making HSA contributions: pre-funding, periodic funding, and “look-back” or post-funding.
- Pre-funding is when an employer puts in the full year’s HSA contribution up-front. Employers may desire to do this as a benefit to employees who may need the money early in the year or in a desire to complete the administration of the HSA early in the year. This method works with some limitations. First, if an employee quits mid-year, the employer cannot re-coup any contribution made to the employee. Second, if a new employee is hired mid-year, the employer is required to treat the new employee comparably generally requiring a contribution for that employee. That employee would be entitled to a pro-rata HSA contribution based on the months of eligibility. The employer can make that contribution monthly or wait until the end of the year to contribute.
- Periodic funding is recommended for most groups. Periodic funding, generally monthly, allows for employees to get access to funds on a regular basis and limits adjustment to new hires or employees that separate from service. Monthly contributions are generally preferred because the IRS works on a monthly basis for comparability purposes. More frequent contribution schedules, weekly or semi-monthly, also work well, as they allow for a monthly determination. Depending upon the HSA contribution amount, the more frequent schedule can result in an increased amount of administrative work for a small dollar contribution amount. Less frequent contributions, for example quarterly, are generally better categorized as pre or post-funding given the need for adjustment for new employees.
- “Look-back funding” is also allowed by the IRS, causing the funding to occur at the end of the year. This allows for employers to easily adjust for new hires and employees separating from service, but most employees are not satisfied with a system that requires them to wait until the end of the year to receive the HSA funding.
Another common desire of businesses, especially small businesses, is to give the owners that also work in the business a larger contribution than non-owner employees. Surprisingly, this may be allowed under the comparability rules for some small business entities, but only because the HSA contribution is treated as shareholder distribution rather than an HSA contribution.
Small business owner issues
Depending on the legal structure of the business,small business owners face special HSA rules that limit the owners’ ability to get tax benefits through the company (These rules could apply to any sized company based on the legal structure, although the employers tend to be smaller in size). Although a business can usually deduct HSA contributions for employees as a business expense and the HSA contributions do not get reported as income to the employees, the rules are different when a business makes HSA contributions to its owners. The treatment varies by type of business entity.
- Sole proprietors. A sole proprietor is not considered an employee for the purposes of business- made HSA contributions (CFR §54.4890 G-3, Q&A 2). Accordingly, sole proprietors are not allowed to deduct their own HSA contributions as a business expense. Instead, sole proprietors can deduct HSA contributions on their personal income tax return. Amounts contributed on behalf of employees generally are deductible as a business expense. This tax treatment may result in the sole proprietor having to pay payroll taxes on the owner’s HSA contribution. One positive of this different treatment is that the owner’s contribution is not subject to the comparability rules. This allows a sole proprietor to give himself a more generous HSA contribution than his employees.
- Partnerships and LLCs. Partnerships and multi-member Limited Liability Companies (single member LLCs are treated the same as sole proprietors) are generally treated as flow-through entities for purpose of HSA contributions made on behalf of the owners. That is, HSA contributions to the owners are not deductible by the business but flow through to the owner as a distribution to the partner (LLC tax treatment varies by state and this discussion does not include LLCs that have elected to be treated as corporations rather than partnerships). The HSA contribution would be reported as a distribution of money on the partner’s Schedule K-1 and the partner can then take a deduction for the HSA contribution on the partner’s personal income tax return.
For this reason, partnerships and LLCs often choose to make a larger shareholder distribution for the owners and let the owners make HSA contributions on their own rather than have the business do it directly. The tax treatment is the same. Contributions made pursuant to a Section 125 plan will be added back to the owners as a taxable fringe benefit negating any tax benefit they might have otherwise received from a Section 125 plan.
An exception exists for guaranteed payments to partners. If a partner is entitled to a guaranteed payment from the partnership, the HSA contribution is deductible by the partnership as a business expense (IRC §162). Unlike non-owner employees, the HSA contribution is also reported as income pursuant to a guaranteed payment on the partner’s K-1 and the partner can then deduct the HSA contribution on his or her personal income tax return.
- S-Corporations. Owners of more than 2 percent of an S-Corporation are treated as partners in a partnership. Contributions made for services rendered are treated as guaranteed payments following the same process for partnership guaranteed payments noted above. S-Corporation HSA contributions to owners may avoid employment taxes (IRS Notice 2004-8, see Q&A 3 noting that if the requirements of IRC § 3121(a)(2)(B) are satisfied then the wages are not subject to employment taxes). Owners also cannot make pre-tax contributions to their HSA via a salary reduction. Any contributions made on their behalf by the corporation are taxable and may be deducted on their personal income tax.
- C-Corporations. Shareholders of normal corporations, C-Corporations, that are also employees are not subject to any special HSA rules and are treated as employees. (Click or touch to enlarge chart.)
Some small business owners are surprised by the different tax treatment of owners versus employees. Small business owners making comparable contributions to non-owner employees under the comparability rules can take a deduction for the amount contributed to employees’ HSAs. Beyond just the reporting differences, the key distinction between the treatments of owners versus employees is payroll taxes. Employer pre-tax HSA contributions avoid the payroll taxes. Employer contributions to small business owners; however, do not automatically avoid payroll taxes and the amounts contributed to the HSA are taxed as shareholder distributions likely to be subject to payroll taxes.
Reduced employer compliance burden due to the HSA custodian role
Given that HSA dollars must be held by an approved HSA custodian or trustee, generally a bank, an employer is relieved of many of the trust and fiduciary obligations found in other benefit programs. The HSA custodian performs the accounting function of tracking deposits and distributions. Given the employer’s limited role, employer-based HSA programs are generally not subject to the Employee Retirement Income Security Act (ERISA). This relieves employers of the burdens ERISA imposes and the requirement to file an annual IRS Form 5500, according to the U.S. Department of Labor, Field Assistance Bulletin 2004-1.
Government reporting obligation
The custodian performs the government reporting function of sending contribution reports (IRS Form 5498-SA) and distribution reports (IRS Form 1099-SA) to both the IRS and the HSA owner.
For reporting purposes, the employer reflects pre-tax HSA contributions, both employer and employee payroll deferral, as non-taxable income on the employees’ Form W-2. Employer contributions and payroll deferral are added together to reflect one number in box 12 of the Form W-2 using a Code W. The employer can deduct the amount on its tax return under the deduction for contributions to an accident and health plan (Code Section 106(d)), a special code section for HSAs and for employee contributions made through payroll deferral pursuant to code section 125.
The IRS uses both the employer-provided Form W-2 information and the custodian provided 5498-SA information to ensure that the employee does not claim a double tax benefit for the HSA contribution both by receiving it pre-tax through the company and then claiming a personal deduction as well.
General administration of the HSA
The custodian also provides the legal document, the custodial agreement (IRS Form 5305-C) that sets forth the basic legal terms of HSAs and generally serves as the first line of contact for both account administration (changing contact information, adding beneficiaries, checking account balance, etc.) and answering basic HSA questions.
The employer’s main administration function is actually making the HSA contributions. This may be done electronically or by sending a check along with a spreadsheet with information allocating the contribution. A key legal issue for employers in this area is that the HSA rules are very strict regarding “recouping” HSA contributions from the employee’s HSA. With limited exceptions, once the employers’ HSA contribution is put into the employee’s HSA, the custodian is not allowed to give the money back directly to the employer. The lesson here for employers is to get the contribution amount correct prior to making the contribution. There are also special rules for employees that fail to open an HSA requiring the employer to hold the funds for a limited period of time to allow the employee an opportunity to open an HSA.
The bulk of the compliance burden for meeting the HSA rules rests with the individual.
- Substantiation. The individual must substantiate that the distributions from the HSA were in fact used for eligible medical expenses by saving medical receipts in case of an IRS audit. Shifting this burden to the individual relieves the employer of the arduous task of reviewing receipts and issuing reimbursement checks or otherwise facing some potential liability for failure by an employee to use the money appropriately. This also allows employees more privacy in their medical spending. (Click or touch to enlarge chart.)
- Eligibility. Although an employer and a custodian can help educate employees on the requirements to be eligible for an HSA, the ultimate responsibility to determine eligibility rests with the employee. An employee’s participation in a spouse’s health insurance plan or Flexible Spending Account (FSA) could jeopardize the employee’s HSA eligibility as could participation in a government health care system such as the Veterans Administration’s plan or Medicare.
- Maximum contribution limit. The individual is primarily responsible to ensure that the amount contributed to the HSA is within federal guidelines. Employers and custodians share the responsibility as employers cannot deduct more than the maximum HSA contribution limit for an employee and custodians cannot accept more than the family HSA limit plus one catch-up contribution ($7,550 maximum for 2014). An employee that exceeds the limit may cause additional administrative work for the employer, the custodian and the individual, so it is in everyone’s best interest to educate the employee on the limits.
- Management of HSA. Employees manage the balance in the HSA, select investments, choose beneficiaries and perform other maintenance issues without employer involvement.
- Tax payments. HSA owners are required to file an attachment to their income tax return each year they make a contribution or take a distribution, the IRS Form 8889. This form is used by the IRS to ensure that the individual does not take a larger than permitted deduction and also ensures that the individual pays any taxes and penalties owed for non-eligible distributions.
- Termination of employment. Another positive feature of HSAs for both employers and employees is that the HSA remains open and viable after the employee’s separation from service. Other than discontinuing any employer contributions into the HSA, the employer does not need to take any action regarding the separating employee’s HSA.
Employers implementing HSA programs benefit from the flexibility HSAs offer. Employers can limit their involvement knowing that employees can avail themselves of the benefits of HSAs on their own outside of the employer benefits program. Alternatively, employers can choose to be generous and make large HSA contributions for their employees, provide a payroll deferral program and still benefit from the relatively light compliance burden HSA programs impose.