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July 2, 2002

TREASURY GUIDANCE ON DEFINED CONTRIBUTION
HEALTH PLANS

On June 26, 2002, the Treasury Department and the Internal Revenue Service (IRS) released guidance discussing health reimbursement arrangements (HRAs). An HRA is an employer- funded account that reimburses an employee for medical care expenses and allows unused amounts to be carried forward for use in later years. To see the guidance (Revenue Ruling 2002-41 and Notice 2002-45) on the IRS's Web site, click here.

The Guidance In Brief

In general, the guidance:

• Provides that an employer-funded HRA may contain a carry-forward feature -- this is the most significant change,
• Stipulates that an HRA may only reimburse documented medical care expenses and cannot pay other types of benefits, such as death benefits or severance payments,
• States that the HRA may be used by both current employees and retirees,
• Clarifies that an employer cannot use salary reduction, either directly or indirectly, to fund an HRA. If it does, the HRA becomes subject to all of the salary reduction rules that apply to flexible spending accounts under Section 125 including the use-it-or-lose-it rule, which bars carry-forwards. (The guidance contains several examples of indirect funding.),
• Permits an employer to structure its plan documents to provide that the HRA will only pay benefits after the employee has used up his or her flexible spending account (FSA ) for a year, and
• Addresses calculation of COBRA premiums for HRA arrangements.

Plan sponsors that implemented an account-based health plan with a carry-forward feature before Revenue Ruling 2002-41 and Notice 2002-45 were issued should revisit their plan designs and assure consistency with the guidance, particularly with respect to salary reduction and coordination of benefit reimbursement with an FSA. Plan sponsors considering implementing an HRA can now examine the various options with clear guidance on the ground rules under the Internal Revenue Code. Of course, in making decisions about HRAs, a plan sponsor should rely on the advice of its attorney on the interpretation and application of laws and regulations.