Under IRS rules, small businesses can reimburse employees for their health insurance in a tax-advantaged way. The most prominent vehicle for doing so is the health reimbursement arrangement (HRA).
When an HRA is compliant with the IRS, companies can reimburse their employees’ health expenses tax-free to both the business and the employees. In this case, all HRA reimbursements are tax-free.
To get the tax benefits, however, an HRA must follow IRS procedures, including strict rules about setting up formal plan documents.
In this post, we'll go over three steps to make sure your company's health insurance reimbursement is tax-free.
1. Set up the HRA to ensure all reimbursements are tax-free
The IRS has clear rules that govern how HRAs work and how companies must set them up to be compliant. To get the tax benefits, an HRA must meet the following requirements:
- 100 percent company-funded (employees can’t contribute).
- The company can’t fund its contribution by cutting the employee’s salary — even if the employee agrees to it.
- Employees must have minimum essential coverage to get reimbursements free of income tax.
- Formal plan documents must define qualified medical expenses.
Certain types of HRAs, like the qualified small employer HRA (QSEHRA). have annual contribution limits, while others (like the one-person stand-alone HRA and the group coverage HRA) have no annual contribution limits.
For more information about HRAs, see our post: What is a health reimbursement arrangement (HRA)?
2. Follow general HRA compliance rules
To be compliant, health care reimbursement plans need to follow the IRS structure and formal plan document procedures. It’s not enough to simply ask employees to show receipts for health care and then reimburse them. Without formal plan documents, reimbursements are not compliant and not tax-free.
If a business doesn’t want to set up compliant documents and procedures, it can just give employees a raise—sometimes called an informal wage increase. However, the company will pay payroll tax on this extra money, and employees will pay both payroll and income tax.
3. Choose a compliant health reimbursement option
Three health care reimbursement options are compliant with IRS rules: the qualified small employer health reimbursement arrangement (QSEHRA), the one-person stand-alone HRA, and the group HRA.
For all three compliance options, reimbursements are always tax-free to the company (no payroll tax) and free of income tax for employees. However, employees can only receive reimbursements tax-free if they have minimum essential coverage (MEC). If employees do not have MEC, they must report reimbursements as taxable income at the end of the year.
With the QSEHRA, health insurance reimbursements are not taxable for companies or employees.
With the proper plan documents in place, businesses won’t pay payroll tax on reimbursements. For employees, all reimbursements through the QSEHRA are free of payroll tax and free of income tax, provided the employee has MEC.
The one-person stand-alone HRA
A one-person stand-alone HRA is only compliant for one person. Even so, companies that use the one-person stand-alone HRA must still create formal plan documents and adhere to IRS rules for HRAs. Assuming the proper plan documents are in place, health reimbursements are tax deductible for the company and tax-free for the employee.
The group coverage HRA
The group coverage HRA is combined with group health insurance—usually a high-deductible health plan (HDHP). With the group coverage HRA, companies can reimburse employees for out-of-pocket health expenses like deductibles, copays and coinsurance costs. Like the one-person stand-alone HRA, companies can also choose to allow balances to roll over from year to the next.
The tax-advantaged nature of HRAs makes them a good option for companies that want to offer personalized, flexible health benefits to their employees. Compliance is key, however. Without it, businesses and their employees can miss out on the tax savings.
Administrative software makes it easy for companies to set up their formal plan documents and keep track of reimbursement requests.