Medical Expense Reimbursements for Non-Dependent Beneficiary Renders All HRA Reimbursements Taxable
September 21, 2006
In Revenue Ruling 2006-36, the Internal Revenue Service (IRS) held that payments under a health reimbursement arrangement (HRA) that provided for reimbursement of medical expenses for a non-spouse, non-dependent beneficiary of an employee were not excluded from the employee’s gross income under Section 105(b) of the Internal Revenue Code (the Code). Further, the IRS held that all reimbursements from the HRA, even those to the employee, the employee’s spouse and the employee’s dependents, should be included in the employee’s gross income. The ruling is effective for plan years beginning after December 31, 2008 for plans in existence on or before August 14, 2006 that contain such reimbursement provisions.
The HRA at issue in the ruling was funded solely by the employer, included no salary reduction elections by the employee, and only provided for reimbursement to the employee for medical expenses that were substantiated and met the definition of “qualifying medical expenses” under Code Section 213(d). Qualifying medical expenses of current and former employees and their spouses and dependents were covered under the HRA up to an annual maximum dollar amount, and any unused amounts carried over into the next year. If an employee died, the qualifying medical expenses of his surviving spouse and dependents were reimbursed. If the employee died without a surviving spouse or dependents, or if the surviving spouse and all dependents died, the HRA reimbursed a beneficiary designated by the employee for the beneficiary’s qualifying medical expenses. Under the terms of the HRA, any reimbursements from the HRA to the beneficiary were taxable to the designated beneficiary. No other present or future benefits were available to the employee or any other person.
Typically, under Section 105(b) of the Code, an employee’s gross income does not include amounts paid to the employee, either directly or indirectly, for reimbursement of medical expenses of the employee or the employee’s spouse or dependents, provided the expenses meet the definition of qualifying medical expenses under Code Section 213(d). In Notice 2002-45, the IRS stated that HRAs qualify for the gross income exclusion under Code Section 105(b) if they only reimburse medical expenses that meet the definition in Code Section 213(d). The notice explicitly stated that if any person can receive cash or other benefits (taxable or non-taxable) besides medical expense reimbursement from the HRA, then all payments from the HRA are included in the employee’s gross income.
The IRS also looked to Situation 3 of Revenue Ruling 2005-24, which held that payments from a plan that provided for reimbursement to a designated non-spouse, non-dependent beneficiary were includable in the employee’s gross income and did not qualify for the Code Section 105(b) exclusion. Although this prior revenue ruling did not specifically address the reimbursement of Code Section 213(d) medical expenses to a non-dependent beneficiary, it did state that it applied to any medical expense reimbursement arrangement provided by an employer that allowed for a benefit other than the reimbursement of medical expenses of the employee, spouse or dependents.
In Revenue Ruling 2006-36, the IRS reasoned that payments from the HRA at issue did not qualify for the Code Section 105(b) exclusion. The main reason for the ruling was that the HRA allowed non-spouse, non-dependent beneficiaries to receive a benefit. Of note in this ruling is that the IRS combined the reasoning in Notice 2002-45 and Revenue Ruling 2005-24 to hold that all payments made under the HRA at issue are included in the employee’s gross income. Thus, even if all reimbursements paid from the HRA are made to the employee, spouse or dependents, the employee is taxed on all of these payments merely because the plan language provides for the possibility that someone other than the employee, spouse or dependents could receive a reimbursement for medical expenses. In other words, the possibility of reimbursement of expenses of a non-dependent beneficiary taints the entire HRA and makes all reimbursements taxable. While not directly addressed in the ruling, the IRS has informally indicated that an HRA can still reimburse expenses for non-dependent domestic partners, provided the value of the coverage attributable to the domestic partner is included in the employee's income and taxed to the employee.
Employers should examine the language of their HRA plan documents to ensure they comply with this ruling. Because of the effective date of the ruling, plans in existence on or before August 14, 2006 have until the 2008 plan year to make any necessary amendments.
Another issue arising from this ruling is whether the same result applies to flexible spending accounts (FSAs) that allow for reimbursement of expenses for a non-spouse, non-dependent beneficiary. Revenue Ruling 2006-36, coupled with Revenue Ruling 2005-24, indicates that any reimbursement for medical expenses from an FSA that benefits non-dependents may be taxable because FSAs are reimbursement accounts like HRAs. However, unlike HRAs, FSAs include a salary reduction election by the employee and are not necessarily comparable enough to HRAs to be bound by this ruling. Nonetheless, employers should consider amending their FSA plans as well to remove provisions allowing reimbursements for expenses of non-spouse, non-dependent beneficiaries.
