Advising employers on health savings accounts

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.

1. 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.
2. 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.
3. “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.

Employee’s responsibility 

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.