Health Care Account Choices for Law Firms

A disadvantage of an FSA is the 'use it or lose it' rule associated with the plan. This means that all amounts contributed to the plan must be spent by the end of the year or risk losing the remaining balance. Law firms should advise their employees to base salary deductions on their estimated out-of-pocket medical expenses. This is not always that easy to do, as people don't plan when to get sick. In order to alleviate this problem, the IRS introduced a 2.5-month rule that allows for reimbursement of expenses incurred up to 2.5 months after the end of the plan year. Adoption of this rule requires an amendment to the plan document. If you have an FSA plan that predates 2005, you should check whether the amendment has been made.

The FSA can only reimburse substantiated medical expenses. Substantiation includes a written statement from an independent third party verifying the medical expense, and a written statement from the employee stating that the expense is not covered by any other plan. The IRS also allows the issuance of FSA debit cards that employees may use for qualified medical expenses. In order to meet the substantiation requirements, the law firm must limit the use of the debit card to medical care providers and stores with a proper merchant category code or stores with an inventory approval system. In addition, the employee must sign a written agreement that the card will be used only for medical expenses, that he/she will not request to be reimbursed for the expense from another source and will keep proper documentation relating to the expense.

Health Reimbursement Arrangements (HRA)

The HRA is another vehicle law firms can use to reimburse employees for medical expenses. The HRA operates very much like an FSA with some differences. The first difference is that an HRA is funded solely by law firm contributions whereas an FSA can be funded by both law firm and employee contributions. Second, the HRA doesn't have the 'use it or lose it rule'; unused balances may be carried over to a subsequent year. Third, an HRA can be used to reimburse health insurance premiums paid by the employee. Unlike an FSA, an HRA is not subject to the requirement that the maximum amount of reimbursement must be available at all times during the period of coverage (i.e., the annual contribution must be available from day one of the plan year). Neither the FSA nor the HRA have statutorily imposed contribution limits, however, the law firms may set their own contribution limits. An HRA is similar to a FSA in that it is only available to employees. Therefore, law firm partners and more than 2% S Corporation shareholders are not eligible.

The rule prohibiting the funding of an HRA through salary reduction can become complicated in a situation where the law firm provides an HRA in conjunction with another health plan that is subject to salary reduction. In some cases, the salary reduction will be attributed to the HRA, rendering it invalid. For example, if the salary reduction for a health plan exceeds the actual cost of the health plan, the salary reduction will be attributed to the HRA. Furthermore, if the law firm structured the HRA in such a way that the amount of the reimbursement is dependent on the amount the employee elects to deduct from salary for the related health plan, the salary reduction will be attributed to the HRA.

If a law firm maintains both an HRA and FSA, the amounts available under an HRA must be expended before reimbursements may be made from the FSA. Since the amounts in the FSA must be expended in the current year and the HRA amounts can be carried forward to the subsequent year, it is more advantageous to use the funds in the FSA first. In order to circumvent the ordering rules, the law firm may specify in the HRA plan document that the HRA coverage is only available after amounts exceeding the dollar amount of the FSA have been paid.

Health Savings Accounts (HSA)

An HSA is an account set up by an individual to pay for medical expenses. The account is analogous to an Individual Retirement Account in that the contributions made by the individual are tax deductible and the earnings on the account grow tax free. The individual's law firm may also contribute to the account. The employer contributions are not taxable income to the employee. In order to be eligible to make contributions to an HSA, the individual must be covered only by a 'high deductible health plan.' Such a plan is determined based on the plan's annual deductibles (at least $1,100 for single coverage and $2,200 for family coverage) and the out-of-pocket expense limits (not to exceed $5,500 for single and $11,000 for family). Generally speaking, if an employee is covered under a FSA or HRA, this constitutes medical coverage and will preclude that individual from setting up an HSA. HSAs are not restricted to employees. Therefore, law firm partners and S Corporation shareholders are eligible. The individual can make tax-free distributions from the account as long as the distributions are used for qualified medical expenses. If the distribution is not used for qualified medical expenses, it must be included in the individual's taxable income and is subject to a 10% penalty.

For 2008, the maximum annual contribution is $2,900 for self-only coverage and $5,800 for family coverage. This limitation includes both employer and employee contributions. Individuals age 55 to 65 may make additional catch-up contributions of $900 in 2008 (increasing to $1,000 in 2009). A married couple may make two catch-up contributions as long as both spouses are at least 55. An individual is entitled to make a full deductible contribution for the year even if he/she becomes eligible later in the year. Contributions in excess of the maximum allowable amounts are not deductible and are taxable to the employee if made by the employer. In addition, excess contributions are subject to a 6% excise tax. Law firms also need to be aware of the comparable contribution requirements. If a law firm contributes to an HSA on behalf of any employee, it must contribute a comparable amount on behalf of every employee with comparable coverage. Contributions are comparable if they are either the same amount or the same percentage of the high deductible plan's annual deductible. Violation of the comparable contribution requirement can be expensive, i.e., a 35% excise tax of the total employer HSA contributions for the period.

A couple of years ago, Congress passed legislation allowing transfers from FSAs and HRAs to HSAs. The maximum amount that can be transferred is the lesser of the balance in the employee's HSA or HRA as of Sept. 21 2006, or the balance as of the date of distribution. The distribution must be completed before Jan. 1, 2012. Law firms should have records available of all employees' FSA and HRA Sept. 21 2006 balances in case they decide to transfer to an HSA in the future. The amounts transferred do not count as contributions in computing the maximum deductible annual contribution. In addition the transferred balances are not included in the employee's taxable income. If a law firm allows one employee to make a transfer from a FSA or HRA to an HSA, it must allow all employees covered by a high deductible plan to do the same. As we noted above, an individual cannot simultaneously have a FSA and HSA. This allowance of account-to-account transfer should be seen as an effective way to transition from a FSA to an HSA and not forfeit the amounts remaining in the FSA under the use it or lose it rules.

Congress also allowed a one-time rollover from an IRA to an HSA. The rollover can be made from either a traditional IRA or a Roth IRA and must be done via a direct trustee to trustee transfer. The amount of the rollover cannot exceed the annual deductible contribution limit.

Conclusion

The area of health care accounts is very complicated. Law firms have various choices in how to structure employee health care accounts. Each choice has its advantages and disadvantages. Law firms should engage competent professionals to help guide them through this complex maze.

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Richard H. Stieglitz, a member of this newsletter's Board of Editors, is a tax partner and Martin Arking is a tax manager in the New York accounting firm of Anchin, Block & Anchin, LLP which specializes in providing accounting, tax and consulting services to law firms. Mr. Stieglitz can be reached at 212-840-3456 or via e-mail at [email protected].

With the rising care of health costs, many law firms are finding it economically difficult to provide their employees with health insurance. One of the ways law firms are mitigating this issue is by offering health insurance plans with greater employee out-of-pocket expenses. Congress offers several types of tax-favored accounts that a law firm can provide to its employees that can be used to pay for these additional medical expenses. Each type of account comes with advantages and disadvantages, which are explored in this article.

Flexible Spending Arrangements (FSA)

An FSA is an account that a law firm can set up for its employees in which the employee contributes pre-tax earnings to the plan and then uses the money in the account to pay for qualified medical expenses. Under a typical arrangement, the FSA is funded through salary reduction. The money is then distributed from the account to reimburse the employee for his (or his dependents') medical expenses that are not covered by his health insurance. These distributions are not taxable to the employee. All employees are eligible regardless of their health insurance coverage status. It is important to note that law firm partners and law firm shareholders owning more than 2% in an S corporation are not considered employees for this purpose and consequently are not eligible to participate in a FSA. Qualified medical expenses are defined as disbursements that qualify as deductible medical expenses under Internal Revenue Code Section 213. This includes dental and vision care. The IRS has ruled that non-prescription medicine such as antacids, allergy medicine, pain reliever and cold medicine qualify. On the other hand, dietary supplements such as vitamins do not qualify.

A disadvantage of an FSA is the 'use it or lose it' rule associated with the plan. This means that all amounts contributed to the plan must be spent by the end of the year or risk losing the remaining balance. Law firms should advise their employees to base salary deductions on their estimated out-of-pocket medical expenses. This is not always that easy to do, as people don't plan when to get sick. In order to alleviate this problem, the IRS introduced a 2.5-month rule that allows for reimbursement of expenses incurred up to 2.5 months after the end of the plan year. Adoption of this rule requires an amendment to the plan document. If you have an FSA plan that predates 2005, you should check whether the amendment has been made.

The FSA can only reimburse substantiated medical expenses. Substantiation includes a written statement from an independent third party verifying the medical expense, and a written statement from the employee stating that the expense is not covered by any other plan. The IRS also allows the issuance of FSA debit cards that employees may use for qualified medical expenses. In order to meet the substantiation requirements, the law firm must limit the use of the debit card to medical care providers and stores with a proper merchant category code or stores with an inventory approval system. In addition, the employee must sign a written agreement that the card will be used only for medical expenses, that he/she will not request to be reimbursed for the expense from another source and will keep proper documentation relating to the expense.

Health Reimbursement Arrangements (HRA)

The HRA is another vehicle law firms can use to reimburse employees for medical expenses. The HRA operates very much like an FSA with some differences. The first difference is that an HRA is funded solely by law firm contributions whereas an FSA can be funded by both law firm and employee contributions. Second, the HRA doesn't have the 'use it or lose it rule'; unused balances may be carried over to a subsequent year. Third, an HRA can be used to reimburse health insurance premiums paid by the employee. Unlike an FSA, an HRA is not subject to the requirement that the maximum amount of reimbursement must be available at all times during the period of coverage (i.e., the annual contribution must be available from day one of the plan year). Neither the FSA nor the HRA have statutorily imposed contribution limits, however, the law firms may set their own contribution limits. An HRA is similar to a FSA in that it is only available to employees. Therefore, law firm partners and more than 2% S Corporation shareholders are not eligible.

The rule prohibiting the funding of an HRA through salary reduction can become complicated in a situation where the law firm provides an HRA in conjunction with another health plan that is subject to salary reduction. In some cases, the salary reduction will be attributed to the HRA, rendering it invalid. For example, if the salary reduction for a health plan exceeds the actual cost of the health plan, the salary reduction will be attributed to the HRA. Furthermore, if the law firm structured the HRA in such a way that the amount of the reimbursement is dependent on the amount the employee elects to deduct from salary for the related health plan, the salary reduction will be attributed to the HRA.

If a law firm maintains both an HRA and FSA, the amounts available under an HRA must be expended before reimbursements may be made from the FSA. Since the amounts in the FSA must be expended in the current year and the HRA amounts can be carried forward to the subsequent year, it is more advantageous to use the funds in the FSA first. In order to circumvent the ordering rules, the law firm may specify in the HRA plan document that the HRA coverage is only available after amounts exceeding the dollar amount of the FSA have been paid.

Health Savings Accounts (HSA)

An HSA is an account set up by an individual to pay for medical expenses. The account is analogous to an Individual Retirement Account in that the contributions made by the individual are tax deductible and the earnings on the account grow tax free. The individual's law firm may also contribute to the account. The employer contributions are not taxable income to the employee. In order to be eligible to make contributions to an HSA, the individual must be covered only by a 'high deductible health plan.' Such a plan is determined based on the plan's annual deductibles (at least $1,100 for single coverage and $2,200 for family coverage) and the out-of-pocket expense limits (not to exceed $5,500 for single and $11,000 for family). Generally speaking, if an employee is covered under a FSA or HRA, this constitutes medical coverage and will preclude that individual from setting up an HSA. HSAs are not restricted to employees. Therefore, law firm partners and S Corporation shareholders are eligible. The individual can make tax-free distributions from the account as long as the distributions are used for qualified medical expenses. If the distribution is not used for qualified medical expenses, it must be included in the individual's taxable income and is subject to a 10% penalty.

For 2008, the maximum annual contribution is $2,900 for self-only coverage and $5,800 for family coverage. This limitation includes both employer and employee contributions. Individuals age 55 to 65 may make additional catch-up contributions of $900 in 2008 (increasing to $1,000 in 2009). A married couple may make two catch-up contributions as long as both spouses are at least 55. An individual is entitled to make a full deductible contribution for the year even if he/she becomes eligible later in the year. Contributions in excess of the maximum allowable amounts are not deductible and are taxable to the employee if made by the employer. In addition, excess contributions are subject to a 6% excise tax. Law firms also need to be aware of the comparable contribution requirements. If a law firm contributes to an HSA on behalf of any employee, it must contribute a comparable amount on behalf of every employee with comparable coverage. Contributions are comparable if they are either the same amount or the same percentage of the high deductible plan's annual deductible. Violation of the comparable contribution requirement can be expensive, i.e., a 35% excise tax of the total employer HSA contributions for the period.

A couple of years ago, Congress passed legislation allowing transfers from FSAs and HRAs to HSAs. The maximum amount that can be transferred is the lesser of the balance in the employee's HSA or HRA as of Sept. 21 2006, or the balance as of the date of distribution. The distribution must be completed before Jan. 1, 2012. Law firms should have records available of all employees' FSA and HRA Sept. 21 2006 balances in case they decide to transfer to an HSA in the future. The amounts transferred do not count as contributions in computing the maximum deductible annual contribution. In addition the transferred balances are not included in the employee's taxable income. If a law firm allows one employee to make a transfer from a FSA or HRA to an HSA, it must allow all employees covered by a high deductible plan to do the same. As we noted above, an individual cannot simultaneously have a FSA and HSA. This allowance of account-to-account transfer should be seen as an effective way to transition from a FSA to an HSA and not forfeit the amounts remaining in the FSA under the use it or lose it rules.

Congress also allowed a one-time rollover from an IRA to an HSA. The rollover can be made from either a traditional IRA or a Roth IRA and must be done via a direct trustee to trustee transfer. The amount of the rollover cannot exceed the annual deductible contribution limit.

Conclusion

The area of health care accounts is very complicated. Law firms have various choices in how to structure employee health care accounts. Each choice has its advantages and disadvantages. Law firms should engage competent professionals to help guide them through this complex maze.

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Richard H. Stieglitz, a member of this newsletter's Board of Editors, is a tax partner and Martin Arking is a tax manager in the New York accounting firm of Anchin, Block & Anchin, LLP which specializes in providing accounting, tax and consulting services to law firms. Mr. Stieglitz can be reached at 212-840-3456 or via e-mail at [email protected].