James E. Kellett and Seth T. Perretta ()
With 2018 fast approaching, many have begun to focus on the Affordable Care Act’s (ACA’s) high-cost or “Cadillac Plan” excise tax, which would impose a 40 percent excise tax on employer-paid health care that is valued over certain thresholds. This provision is seen as an effective “cap” or limitation on an employer’s and employee’s ability to utilize the current income exclusion for employer-paid coverage.
Many employers may be unaware, however, of recent guidance that was issued by the IRS, in conjunction with the Departments of Labor and Health and Human Services (collectively, the Departments), which will limit today an employer’s and employee’s ability to utilize the current federal income and payroll tax advantages for employer-paid health care. More specifically, pursuant to IRS Notice 2013-54 and DOL Technical Release 2013-03, various long-standing tax-preferred arrangements will no longer be permitted.
This article provides a brief overview of these new rules and their implications to common employer-sponsored arrangements. Employers and attorneys alike should review and carefully understand these new rules to ensure that existing and planned health financing arrangements comply with these new rules.
Background. Pursuant to long-standing federal tax rules, certain employer-paid health care is excludable from an employee’s income for federal income and payroll tax purposes. Additionally, such employer-paid health care is also excludable from an employee’s income for purposes of determining an employer’s share of the payroll tax liability attributable to the wages paid to the employee.
The ACA’s market reforms impose a host of restrictions on individual insurance and insured or self-funded employer-sponsored group health plans. Of special relevance to the discussion at hand, one of these market reforms prohibits the imposition of annual or lifetime dollar limits on what are called “essential health benefits” for plan or policy years beginning on or after Jan. 1, 2014 (Dollar Limit Prohibition). Very generally, essential health benefits are defined by reference to state-specific benchmarks and are, by statute, the types of benefits typically covered by an employer-sponsored plan. A second of these market reforms requires that any individual insurance policy or group health plan, whether insured or self-funded, cover certain preventive care benefits without any cost-sharing by the enrollee or participant (Preventive Care Requirement). This second market reform has been in effect for several years now.
Significantly, certain types of group health plans that constitute “excepted benefits” for purposes of the provisions of the Health Insurance Portability and Accountability Act (HIPAA) are not subject to these reforms, such as stand-alone dental and vision plans, certain qualifying health flexible spending arrangements (Health FSAs), Medicare supplemental plans, and insured fixed and hospital indemnity plans, among others.
In addition to these market reforms, the ACA also includes an express statutory prohibition against an employee’s use of an employer’s Internal Revenue Code (IRC) §125 plan to pay for individual insurance purchased through a public exchange (or the Marketplace in the case of the federally-facilitated exchange). Lastly, the ACA amends the IRC to allow for the provision of certain premium tax credits and cost-sharing reductions to help lower-income individuals afford individual health insurance purchased through a public exchange, such as the federally-facilitated Marketplace (Premium Tax Credits). However, the operative IRC provision, §36B, provides that an individual is not eligible for Premium Tax Credits if he or she has access to affordable, qualifying employer-sponsored health coverage or is enrolled in qualifying coverage regardless of its affordability.
Many questions have arisen regarding how these rules apply to potentially restrict access to, and/or sponsorship of, certain commonly-used employer-sponsored health arrangements, including the following:
• IRC §125 cafeteria plans for use by employees in paying for coverage on a pre-tax basis (Cafeteria Plans);
• Stand-alone health reimbursement arrangements (Stand-Alone HRAs) for active employees;
• Retiree-only stand-alone health reimbursement arrangements (Retiree-Only HRAs);
• Employer payment plans or other direct employer-paid premium subsidy arrangements (EPPs);
• Health flexible spending arrangements (Health FSAs).
Last fall, the IRS issued Notice 2013-54, “Application of Market Reform and other Provisions of the Affordable Care Act to HRAs, Health FSAs, and Certain Other Employer Healthcare Arrangements.” On the same date, the Departments issued near-identical guidance (collectively, the Guidance). The Guidance provides helpful clarification on how these rules apply to these types of arrangements. However, as discussed below, the guidance appears to significantly curtail the manner in which these arrangements may be used on a going-forward basis. Additionally, certain questions remain.
Stand-alone HRAs for active employees may only be used where integrated with other employer-sponsored major medical insurance. Of great interest to many employers, the Guidance reiterates past guidance from the Departments that an employer cannot sponsor a health reimbursement arrangement or “HRA” for its active employees, unless the HRA is “integrated” with an underlying major medical plan that does not consist solely of HIPAA-excepted benefits. Thus, an HRA must be only available to employees who are enrolled in qualifying employer-sponsored major medical coverage.1 The basis for the conclusion is that such arrangements cannot by their terms comply with the Dollar Limit Prohibition and Preventive Care Requirement.
Since Stand-Alone HRAs cannot meet the market reform requirements of the ACA, it appears that they will no longer be a viable means for employers to subsidize an employee’s cost of individual insurance on a tax-free basis. This is an important clarification because it means that employers may lack the means to subsidize the costs of an employee’s individual insurance on a tax-preferred basis. As a result, the cost of coverage for the employee will effectively increase because the employee would end up having additional taxable wages for federal income and payroll tax purposes, all other things being equal. The employer could find itself subject to increased payroll tax liability as well.
Some employers may have been and/or be considering using HRAs for active employees in connection with coverage that qualifies as a HIPAA excepted benefit. As noted above, the ACA’s market reforms do not generally apply to HIPAA excepted benefits. While the Guidance, coupled with a proposed rule issued by the Departments on Dec. 20, 2013, should permit employers to use HRAs in connection with HIPAA-excepted coverage (in terms of subsidizing an employee’s cost of coverage or allowing for employee reimbursements of cost-sharing associated with the coverage), employers and attorneys must be careful to ensure that the HRA does not provide benefits of the type that could render the related coverage no longer HIPAA-excepted. One example of this is where an HRA is offered alongside stand-alone dental coverage, and not only reimburses cost-sharing incurred by the enrollee for covered dental services, but also reimburses other non-dental medical expenses. Such a structure would likely result in the dental coverage no longer being HIPAA-excepted and in the arrangement as a whole constituting non-compliant ACA-governed coverage.
Retiree-only HRAs are permitted, but may disqualify pre-65 retirees from being eligible for premium tax credits. Per prior Department guidance, employer-sponsored group health plans that cover only retirees are not subject to the ACA’s market reforms. Consistent with this past direction, the Guidance provides that an employer may offer a Retiree-Only HRA regardless of whether it is integrated with other medical coverage.
Employers should keep in mind, however, that retirees who have not yet reached age 65 may be disqualified from being eligible for federal Premium Tax Credits for the purchase of individual insurance through a public exchange by reason of the Retiree-Only HRA coverage. One strategy that may be available to avoid such disqualification is to provide an annual enrollment right to retirees with respect to the HRA coverage. More specifically, it appears possible under existing rules that an employer could allow individuals an opportunity to “enroll” in the HRA for the upcoming year. To the extent the individual elects not to enroll, then the HRA would be effectively “turned off” for the following year, i.e., the individual would not be eligible to reimburse from the HRA any expenses incurred during that year.
Employers cannot utilize an EPP or a similar arrangement to subsidize an employee’s individual insurance in a tax-preferred manner. In addition to HRAs, the Guidance applies, in part, to “certain other employer healthcare arrangements,” including what the Departments refer to as “employer payment plans” or EPPs. An EPP is defined in the Guidance as a “group health plan under which an employer reimburses an employee for some or all of the premium expenses incurred for an individual health insurance policy … or arrangement under which the employer uses its funds to directly pay the premium for an individual health insurance policy covering the employee.” Long-standing IRS Revenue Ruling 61-146 held that, if an employer reimburses an employee’s premiums for non-employer-sponsored medical insurance, the payments are excluded from the employee’s gross income under the IRC. An EPP only includes amounts that are paid by the employer on a pre-tax basis, not an employer-sponsored arrangement under which an employee can use after-tax dollars toward health coverage.
While EPPs have historically been rather obscure vehicles for providing health coverage to employees, following the enactment of the ACA, some had thought that EPPs could be a means for allowing employers to provide employees with tax-free health care coverage, while eliminating the employer’s need to provide an employer-sponsored group health plan (since employees would be required under the plan to purchase individual insurance policies). While Revenue Ruling 61-146 provided an argument that such arrangements would be subject to preferred tax treatment, it left unanswered whether such an arrangement would qualify as a “group health plan” for purposes of the ACA and, if so, whether EPPs would suffer from the same infirmities as Stand-Alone HRAs in their attempt to comply with ACA market reforms.
The Guidance answers this question. More specifically, it clarifies that EPPs are not a viable means of providing employer-sponsored coverage for purposes of the ACA. This is because, similar to Stand-Alone HRAs for active employees, the Guidance provides that an EPP is a group health plan, but is not considered “integrated” with any individual insurance policy purchased under the arrangement. Accordingly, the Guidance provides that an EPP is subject to ACA’s market reforms, principally because it cannot meet the Dollar Limit Restriction or the Preventive Care Requirement.
Cafeteria plans are off-limits for exchange-based individual insurance; questions remain regarding use for non-exchange-based individual insurance. Except for limited transition relief, effective for tax years beginning after Dec. 31, 2013, employees who purchase individual insurance through the federally-facilitated Marketplace or other public exchange may not pay for such coverage on a pre-tax basis. This typically could only be achieved through an employee’s use of his or her employer’s IRC §125 Cafeteria Plan. As noted above, this rule is based on express statutory language included in the ACA. The result of this change is that, for employees that historically paid for their share of premiums through their employer’s Cafeteria Plan, their cost of coverage will increase by an amount equal to the cost of coverage, multiplied by their effective marginal federal income tax rate. Additionally, loss of access to a Cafeteria Plan could increase employees’ payroll tax liability and that of the employer by the amount of coverage (depending on their wages relative to the Social Security wage base).
What is not entirely clear under the statute and the Guidance is whether an employer could make available a Cafeteria Plan to permit its employees to pay on a pre-tax basis for individual insurance purchased outside of a public exchange. These types of arrangements are commonly called “premium-only plans” or “POPs.” Part of the uncertainty appears to stem from confusion about whether a POP should qualify as an EPP (see above for a discussion of EPPs under the Guidance). We understand the Departments are continuing to consider this question; however, a very reasonable reading of existing law and the Guidance is that POPs are no longer permitted.
To the extent that POPs are no longer permitted, this should result in a similar increase in costs for employers and employees after taking into account the tax effects. Additionally, to the extent that POPs are no longer permitted, this would seem to very likely slow down the growth in the use of private exchange arrangements by employers for their active employee populations. This is because, to the extent that an employer could not make available a POP for use by its employees in paying for individual insurance purchased through a private exchange, this would result in a relative cost increase for employees and employers. Accordingly, many providers and administrators of private exchanges continue to seek clarification on whether POPs may be used with respect to individual insurance purchased outside of a public exchange (e.g., via a private, third-party-administered exchange).
Health FSAs may not be offered by an employer to an employee UNLESS the employer also makes available to the employee other major medical coverage. A Health FSA is any employee- or employer-funded account designed to reimburse employees for medical care expenses. They are typically funded by employee contributions through a salary reduction agreement, although employers can also contribute to FSAs on behalf of their employees. Contributions made to a Health FSA offered through Cafeteria Plan do not result in gross income to the employee.
The Guidance provides that a Health FSA that provides only HIPAA excepted benefits is not subject to the ACA’s market reforms.2 However, the Guidance also makes clear that a Health FSA that does not qualify as an excepted benefit is subject to the ACA’s market reforms, including the Dollar Limit Prohibition and the Preventive Care Requirement. Given the defined contribution nature of Health FSAs (with their maximum coverage amounts), it would seem to be the case that Health FSAs that do not qualify as HIPAA-excepted benefits will be unable to satisfy the requisite market reforms and could result in material penalties to the plan sponsor under the ACA’s market reform provisions. Accordingly, employers should review the coverage terms of their Health FSAs and benefit plan offerings more generally to ensure that their Health FSAs qualify as HIPAA-excepted benefits.
Conclusion. Employers and their attorneys should carefully review the Guidance to ensure that their benefit plans comply with the ACA, including the new rules and clarifications set forth in the Guidance. Additionally, because of the potential for benefit plan eligibility or enrollment to disqualify employees and certain retirees from eligibility for federal Premium Tax Credits, employers and counselors should consider strategies to limit unintended collateral effects on past and current employees.
James E. Kellett is a partner at Crowell & Moring in New York and a member of its litigation and trial department and the labor and employment group. Seth T. Perretta is a partner in the Washington, D.C. office and leads the firm’s ERISA and employee benefits practice.
1. Of note, the Guidance does provide that if an employee participating in an integrated HRA loses group health coverage, the employee can still use the amounts remaining in what would then be effectively a “stand-alone” HRA, and the HRA will still be considered ACA-compliant employer-sponsored coverage. Plan sponsors should keep in mind, however, that for any month in which a pre-65 employee is able to access residual amounts in the HRA, they should be disqualified from eligibility for federal Premium Tax Credits for public exchange-based individual insurance.
2. A Health FSA is considered to provide only HIPAA excepted benefits if other group health plan coverage not limited to excepted benefits is made available for the year to employees by the employer, and the FSA is structured so that the maximum benefit payable to any participant cannot exceed two times the participant’s salary reduction election for the arrangement for the year (or, if greater, cannot exceed $500 plus the amount of the participant’s salary reduction election).