Since their inception, health reimbursement arrangements (HRAs) have helped business owners across the U.S. offer affordable and customizable health benefits to their employees. One of the main perks of HRAs—including the qualified small employer HRA (QSEHRA)—is their tax advantages.
With a QSEHRA, any money allocated for the reimbursement of eligible employee medical expenses are payroll tax-free for a company and its employees. Reimbursements are also free of income tax for employees as long as their health insurance policy and employment status within their organization meet specific qualifications. But what exactly does that mean?
In this blog, we’ll walk you through several common employee scenarios that affect the taxability of QSEHRA reimbursements and how employers should report QSEHRA payments during tax season.
What is a QSEHRA?
Before we get into the tax implications, let’s quickly review how a QSEHRA works.
A QSEHRA is a formal health benefit made specifically for small employers with fewer than 50 full-time equivalent employees (FTEs). With it, they can reimburse their employees for their individual health insurance premiums and qualified out-of-pocket medical expenses, including prescription drugs, mental health counseling, and physical therapy.
QSEHRAs are entirely employer-funded using pre-tax dollars. Employers choose a monthly allowance that works for their budget and employees’ needs. While there’s no minimum contribution limit, the IRS updates annual maximum limits for individuals and families.
By law, all full-time W-2 employees are automatically eligible for the QSEHRA, but employers can extend the benefit to part-time employees, too. Eligible employees purchase the best health coverage and medical items for themselves and their families. When an employee submits documentation of an eligible expense, the employer verifies and approves the cost and reimburses the employee up to their available allowance amount.
Unlike health savings accounts (HSAs) or flexible spending accounts (FSAs), HRA funds stay with the employer until the employee incurs a qualified expense. Additionally, all unused funds remain with employers at the end of the year.
Because of its flexibility, the QSEHRA has made offering health benefits a possibility for small business owners who couldn’t meet the participation requirements or annual rate hikes that come with traditional group health plans.
Now that we’ve gone over the ins and outs of the QSEHRA, we’ll look at three scenarios below that impact reimbursement taxability.
1. Employees with a qualified health insurance policy
This first scenario is the most straightforward. Employees with major medical insurance are likely eligible for QSEHRA reimbursements that are free of payroll and income tax. This is because most comprehensive health insurance coverage meets minimum essential coverage (MEC).
Qualified health insurance plan types include the following:
- Individual health insurance: Employees can purchase an individual insurance policy through a public exchange, like the Health Insurance Marketplace, or from a private exchange, like directly from a private insurance company.
- A spouse’s group health insurance: Employers can’t simultaneously offer a group health insurance policy and a QSEHRA. However, if an employer’s QSEHRA allows for employer-sponsored premium reimbursements (ESPR), an employee can receive reimbursements for their spouse’s health insurance premiums.
- However, the premiums will likely1 be taxable reimbursements because the spouse typically pays for the employer-sponsored plan on a pre-tax basis via their paycheck.
- In the rare circumstance where a spouse’s employer doesn’t allow them to pay for their premiums pre-tax, the premium would be eligible for tax-free reimbursement.
- A parent’s health insurance: Employees younger than 26 who are still on their parent’s health insurance plan can receive reimbursements for medical expenses on a tax-free basis if their parent’s plan meets MEC. But they can’t request reimbursement for insurance premiums.
- Medicare: HRAs and Medicare can integrate. But, an employee’s tax liability depends on which Medicare Parts they have. For example, an employee must have Part B and Parts A or C to meet MEC and receive reimbursements free of income tax.
Supplemental health plans, like dental or vision plans, aren't comprehensive health coverage because they only cover specific services and items and don't have essential coverage. Employees would need a qualified health plan in addition to a supplemental plan to receive tax-free reimbursements.
>2. Employees without a health insurance policy
Employees without health coverage or a qualified policy that meets MEC can receive taxable QSEHRA reimbursements. Employers must report all payments made under this scenario as taxable income on their W-2 at the end of the year. Additionally, according to IRS Notice 2017-67, you can exclude taxable reimbursements from wages for federal income tax withholding.
Similarly, healthcare sharing ministry programs aren’t formal health insurance under the Affordable Care Act (ACA). So if you have any employees covered by a Medishare plan, the IRS won’t consider their membership fees or donations a qualified expense for reimbursement.
However, like any employee without health coverage or MEC, Medishare-covered employees can still receive taxable reimbursements for other qualified out-of-pocket medical expenses with their QSEHRA.
As an employer, you must give proper notice to employees without health insurance (or qualified health coverage) about the potential tax consequences in your QSEHRA plan documents. You should also inform them that their future reimbursements will become tax-free if they enroll in a health plan that meets MEC requirements.
3. Employees who are also business owners
QSEHRAs are typically for employees—not business owners. However, depending on their filing status, some business owners can participate in a QSEHRA and take advantage of its tax benefits.
Let’s look at some of those specific situations in the sections below.
The IRS considers C-corporations as independent legal organizations separate from the owner. Because of this, C-corp owners are “common-law” employees of the corporation and are eligible to participate in a QSEHRA.
Like all QSEHRA participants, the owner’s qualified dependents on the QSEHRA can take advantage of the benefit, and all reimbursements to the owner and dependents are payroll and income tax-free if they have MEC.
A sole proprietorship is an unincorporated business owned and run by one individual. By law, there’s no defined separation between the business and its owner. However, QSEHRAs are only for employees. Therefore, sole proprietors can’t participate in a QSEHRA.
If the owner’s spouse is a W-2 employee of the sole proprietorship, the owner could participate in the QSEHRA as their spouse’s dependent on the benefit. In this case, all reimbursements for their insurance premiums and out-of-pocket medical costs are tax-free to the owner and their spouse, provided they have MEC.
A partnership is a pass-through entity. This means the company itself isn’t subject to income tax, and the IRS taxes each partner involved directly. In this situation, the partners within the partnership are self-employed business owners and aren’t eligible to participate in the QSEHRA.
However, like sole proprietors, partners can be eligible dependents on QSEHRA if their spouse is a W-2 employee, not another business partner, and they can receive tax-free reimbursements if they have MEC.
Like partnerships, an S-corporation is a pass-through entity and isn’t subject to income tax. Instead, the IRS taxes shareholders who own at least 2% of the company’s shares directly and individually. This makes shareholders owners of the business not eligible to participate in the QSEHRA.
Shareholder status also extends to family members, including spouses, parents, grandparents, and children, so they aren’t allowed to participate in a QSEHRA either—whether or not they’re company employees or legal dependents.
How to report QSEHRA reimbursements while filing taxes
To fulfill QSEHRA W-2 reporting requirements, you must report each employee’s total QSEHRA allowance in box 12 of the employee’s W-2 using code FF. This amount only indicates the total allowance amount during the plan year—not the amount the employee received in reimbursements.
You should monitor your employees’ coverage status throughout the year to accurately report any reimbursements they may have received if they didn’t have MEC. The IRS considers these reimbursements taxable income, and you must include this amount on their W-2 in box 1 with their wages, tips, and other compensation.
The taxable income listed in box 1 won't affect the amount reported in box 12, code FF.
If you use HRA administration software, like PeopleKeep, you can quickly and easily look back in your dashboard to find out if and when an employee didn’t have MEC during the year. If you need to correct an employee’s W-2 due to a lack of MEC, you can file Form W-2c2 with the Social Security Administration3 to make adjustments.
This will fix your previously submitted Form W-2 and help your employees pay the right amount of income taxes that year.
As always, we recommend contacting a tax professional for financial assistance if you need tax advice when filling out your annual Form W-2s.
The QSEHRA offers many excellent advantages to small businesses and their employees, including tax advantages. Small employers can set the allowance that works best for their budget and aren’t subject to payroll taxes on QSEHRA reimbursements.
And while the greatest tax advantages apply to employees with MEC, all participants can benefit from the QSEHRA and pay for eligible out-of-pocket medical expenses with greater financial security.
This article was originally published on February 19, 2018. It was last updated on October 23, 2023.
Elizabeth Walker is a content marketing specialist at PeopleKeep. She has worked for the company since April 2021. Elizabeth has been a writer for more than 20 years and has written several poems and short stories, in addition to publishing two children’s books in 2019 and 2021. Her background as a musician and love of the arts continues to inspire her writing and strengthens her ability to be creative.