1. How to Avoid HSA and HRA Pitfalls and Traps: A Legal but Practical Perspective Ashley Gillihan, Esq. Alston & Bird, LLP Ashley.gillihan@alston.com 404-881-7390

2. 2 Overview of Traps Trap #1: ERISA Applicability Trap #2: Nondiscrimination Rules Trap #3: HRA Direct and Indirect Funding Rules Trap #4: Disqualifying Coverage Trap #5: New Contribution Rules under HR 6111 Trap #6: Distribution Traps Trap #7: Cafeteria Plan Issues Trap #8: Prohibited Transaction Issues Trap #9: Employee Cash Flow Concerns Trap #10: Monitoring contributions Other compliance issues

3. 3 HSA/HRA Traps and Pitfalls Trap #1: ERISA Applicability

4. 4 ERISA Headaches—Why do we care? DOL Guidance Steps to avoid ERISA applicability

5. 5 Trap #1: ERISA Applicability Headaches if ERISA applies... –Form 5500 –SPD and Plan Document –COBRA Code’s COBRA provisions do not apply but ERISA may –HIPAA Privacy issues –Fiduciary Requirements Code’s Prohibited Transaction Rules apply whether ERISA’s prohibited transaction rules apply or not –Class Action Litigation

6. 6 Trap #1: ERISA Applicability Original view was that HSAs would be treated like IRA’s IRAs that satisfy the following four “Safe Harbor” conditions are not subject to ERISA: –No contributions are made by the employer Pre-tax contributions are employee contributions for DOL purposes –Participation is completely voluntary –The employer does not endorse the program –The employer receives no consideration other than reasonable compensation for services actually rendered Same requirements apply to voluntary group insurance

7. 7 Trap #1: ERISA Applicability DOL issued Field Assistance Bulletin (“FAB”) 2004-1: –Establishes “safe harbor” –DOL found that employer contributions were less significant in determining whether ERISA applies to HSAs so they tweaked the safe harbor to allow for employer contributions without triggering ERISA

8. 8 Trap #1: ERISA Applicability Special Safe Harbor for HSAs –Employers may contribute to an HSA without triggering ERISA so long as the employer satisfies all of the following conditions: Participation is completely voluntary No restrictions on account holder’s ability to move funds to another HSA trustee No restrictions on use of funds other than those permitted by code Does not make or influence investment decisions No “endorsement” by employer Does not receive any payment or compensation

9. 9 Trap #1: ERISA Applicability FAB 2006-02 clarifies aspects of FAB 2004-1 as well as other ERISA related issues –Employer may establish HSA on behalf of employee and make “employer” contribution w/o violating “completely voluntary” requirement Salary reductions from employees must be voluntary in order to satisfy the safe harbor –ERISA is not triggered solely because employer chooses a particular vendor to whom it makes contributions.

10. 10 Trap #1: ERISA Applicability FAB 2006-06 (cont’) –The employer does not “make or influence” investment decisions solely by choosing a vendor that offers same funds as employer’s 401(k) –FICA savings generated through cafeteria plan are not “compensation” to the employer –Employers can pay trustee/custodian fees directly without triggering ERISA –Employer/trustees can offer HSAs to its own employees without triggering ERISA so long as same product offered in normal course of business.

11. 11 Trap #1: ERISA Applicability FAB 2006-06 (cont’) –Employer does receive “compensation” if it receives discount on services offered by vendor in conjunction with HSA –Failing to promptly forward contributions to trust is a prohibited transaction (even if ERISA does not apply) –IRA Class PT exemptions on free or reduced cost services not applicable to HSAs

12. 12 Trap #1: ERISA Applicability Steps to avoid ERISA: –Include clear disclaimer regarding HSA status as an individual financial account – NOT an employer sponsored benefit plan –Review vendor materials –Review enrollment materials –Carefully draft HSA summaries –Review bundled arrangements Look for potential discounts –Proceed with caution if choosing substituting 401(k) funds

13. 13 HSA/HRA Traps and Pitfalls Trap #2: Nondiscrimination Traps

14. 14 Trap #2: Nondiscrimination Traps Tests Applicable to HSAs –Comparability –IRS guidance on comparability rule –Statutory improvements made by HR 6111 Tests Applicable to HRAs –General 105(h) concepts –HIPAA Nondiscrimination

15. 15 Trap #2: Nondiscrimination Traps What is the HSA “Comparability Rule”? –If an employer makes contributions to an individual’s HSA, it must make “comparable contributions” for all “comparable participating employees”

16. 16 Trap #2: Nondiscrimination Traps What is the HSA “Comparability Rule”? –What are “comparable contributions” The same amount or The same percentage of the HDHP deductible covering the employee

17. 17 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Who are comparable participating employees? Employees of employers who are eligible individuals (as defined in Code Sec. 223) with the same level of coverage and fall into one of the following categories: –P/t employees –F/t employees –Former employees (other than those receiving COBRA coverage) Employer may restrict HSA contributions to those who participate in the Employer’s HDHP What about restrictions related to the HSA custodian chosen by employer?

18. 18 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Permitted levels of coverage for purposes of comparability only: Single Family +1 Family +2 Family +3 or more –Amount for lower level cannot be more than next highest level of coverage

19. 19 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Who is NOT a comparable participating employee? Union employees Partners/self-employed Sole proprietors Former employees receiving COBRA coverage under employer’s HDHP With respect to contributions to non-HCEs, HCEs are not comparable participating employees (H.R. 6111)

20. 20 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Comparability Rule measures amounts actually contributed during the calendar year (not just amounts “made available”) HDHP plan year is irrelevant –Allows variations based on service during the year so long as everyone received the same monthly pro-rata amount –Employer agrees to contribute $100 per month to employees’ HSAs. –Bob is employed 12 months and Jim is employed 11 months. –Bob receives $1200 during the year and Jim only receives $1100. Is there a violation?

21. 21 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Timing of contributions under Comparability Rule can be confusing. Pay as you go –Allows me to stop making contributions during the year Catch Up –Must track down former employees who were eligible individuals during the year Pre-pay –May switch methods during the year but cannot stop making contributions

22. 22 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Comparability rule DOES NOT APPLY to HSA contributions “made through the cafeteria plan” When are contributions “made through the cafeteria plan”? –Pre-tax salary reductions –Matching contributions –Non-elective contributions to HSAs of those who were provided “opportunity” to make elective contributions through 125 plan –125 discrimination rules apply.

23. 23 Trap #2: Nondiscrimination Traps What is the HSA Comparability Rule? (cont’) –Recurring Issues and Concerns Part year employees Last day of year vesting rule prohibited What if HSA is never opened –What if opened with “other” trustee Disease management programs and wellness program incentives

24. 24 Trap #2: Nondiscrimination Traps HRA nondiscrimination traps: –Self-insured benefits cannot discriminate in favor of HCEs as to eligibility and benefits –Two tests: Eligibility Test –Could be an issue if HRA offered only to a limited group consisting substantially of HCEs (top 25% in pay) Contributions and Benefits Test –Pass test if same HRA accrual is made available to all participants for same contribution

25. 25 Trap #2: Nondiscrimination Traps HRA nondiscrimination traps (cont’) –Plan Design issues: Allowing only salaried to participate Providing higher annual allocation to salaried than to hourly Providing a higher annual allocation to those with more years of service or higher pay

26. 26 HSA/HRA Traps and Pitfalls Trap #3: HRA Direct and Indirect Funding Rules

27. 27 Trap #3: HRA Direct and Indirect Funding Rules HRA cannot be funded by pre-tax salary reduction (including cashable Flex Credits) under a cafeteria plan An HRA may be offered “in conjunction” with major medical plan under a cafeteria plan provided it is not funded directly or indirectly with pre-tax salary reductions

28. 28 Trap #3: HRA Direct and Indirect Funding Rules Direct Funding: –Employees cannot elect to pay for HRA with pre-tax contributions Salary reduction agreement should indicate that pre-tax contributions do NOT fund HRA –Salary reduction (and otherwise cashable credits) attributable to medical coverage cannot exceed applicable premium for non-HRA medical coverage Applicable premium is determined using COBRA criteria (not including 2% admin charge)

29. 29 Trap #3: HRA Direct and Indirect Funding Rules Indirect Funding: –No positive correlation between salary reduction for medical plan and HRA amount –Impermissible practices HRA and salary reduction amount cannot increase or decrease in tandem –Option 1: HRA=$500/Salary Reduction=$300 –Option 2: HRA=$800/Salary Reduction=$500 Cannot allow employees to elect to use HRA funds to pay for employer coverage in lieu of funding coverage via salary reduction Cannot allow FSA forfeitures to fund HRA

30. 30 Trap #3: HRA Direct and Indirect Funding Rules Indirect Funding (cont’) –Permissible practices Variation between individual/family coverage –Single coverage/HRA of $500/Salary Reduction $300 –Family coverage/HRA of $700/Salary Reduction $500 Threshold correlation (in/out HRA option) Inverse Correlation –HRA amount for multiple options decreases (or increases) as salary reduction amount for multiple options increases (or decreases) Option 1: HRA=$500/Salary Reduction=$300 Option 2: HRA=$800/Salary Reduction=$200

31. 31 HSA/HRA Traps and Pitfalls Trap #4: Disqualifying Coverage

32. 32 Trap #4: Disqualifying Coverage What is a Qualifying HDHP coverage? Permissible benefits below HDHP deductible –The “Three P’s” Preventive Care Permitted Insurance Permitted Coverage Problem Area: State insurance mandates

33. 33 Trap #4: Disqualifying Coverage General Rule –No coverage below deductible except for “three p’s” Traps for the unwary participant –FSA/HRA general purpose coverage –Health FSA coverage with grace period –Executive medical (other than preventive) –Employer sponsored/on site clinics –Coverage under spouse’s plan

34. 34 Trap #4: Disqualifying Coverage What is Preventive Care? –Code Section 223 does not specifically define “preventive care” –Notice 2004-23 provides safe harbor definition of “preventive care” Preventive care includes, but is not limited to, –Periodic health evaluations and routine pre-natal and well-child care –Child and Adult immunizations –Obesity/Weight loss and Tobacco cessation programs –Screening services (specific list of permissible services provided)

35. 35 Trap #4: Disqualifying Coverage What is preventive care? (cont’) –Preventive care DOES NOT include services that treat an existing condition –Ancillary medical procedures that are part of a preventive care service or program do not cause an otherwise preventive care service or treatment to fall outside of the safe harbor so long as it would be unreasonable or impractical to separate the medical procedure from the preventive care service or program Removing polyps during a colon cancer screening procedure

36. 36 Trap #4: Disqualifying Coverage What is preventive care? (cont’) –Drugs that constitute preventive care: A drug that satisfies any of the following 3 conditions is considered “preventive care” Condition #1: –They are taken by an individual with risk factors for a condition that has not yet manifested itself or not yet become clinically apparent (the individual is asymptomatic) Statins to lower cholestorol

37. 37 Trap #4: Disqualifying Coverage What is preventive care? (cont’) –Drugs that are “preventive care” (cont’) –Condition #2: They are taken by an individual to prevent the recurrence of a disease from which the person has recovered –ACE inhibitors for heart attack and stroke victims

38. 38 Trap #4: Disqualifying Coverage What is preventive care? (cont’) –Drugs that are “preventive care” (cont’) Condition #3: –The drugs are taken as part of a preventive care program Drugs taken as part of a smoking cessation program or weight loss program

39. 39 Trap #4: Disqualifying Coverage “ Permitted coverage” is coverage for any of the following: –Dental –Vision –Long term care –Accidents –Disability An example: school or sports accident/injury coverage

40. 40 Trap #4: Disqualifying Coverage “Permitted Insurance” is: –Insurance where substantially all of the coverage relates to: Workers’ compensation liability Tort liabilities Property/landowner liabilities –Insurance for a specified disease or illness –Insurance paying a fixed amount per day of hospitalization e.g., Hospital Indemnity –Generally must be provided pursuant to a commercial insurance contract

41. 41 Trap #4: Disqualifying Coverage PLR 200704010 regarding the 3 P’s: –coverage triggered solely by cancer (or another specified disease), including first occurrence benefits, progressive benefits, ROP benefits, and specified treatment indemnities triggered by cancer are permissible –preventive and screening benefits attached as riders to permissible benefits are permissible –a fixed indemnity policy with initial benefits triggered by heart attack, heart disease, or stroke is permissible (but no benefits are paid for any sickness, disease, or incapacity resulting from heart attack, heart disease or stroke) –fixed indemnities under HIP for treatment associated with a HIP such as surgery, ambulance, etc is not permissible –accident or disability only indemnities are permissible

42. 42 Trap #4: Disqualifying Coverage Health FSA and HRA coverage –General Rule: Can’t be an Eligible Individual if you have general purpose Health FSA and/or HRA coverage (Rev. Rul. 2004-45).

43. 43 Trap #4: Disqualifying Coverage Health FSA/HRA coverage (cont’) –Situations in which you can have Health FSA and still be an Eligible Individual –Health FSA coverage is limited to: Expenses incurred after statutory minimum deductible is met (Post Deductible) –Pays after HDHP’s deductibles have been satisfied –Pays after own high deductible has been satisfied –Difficult Administration Issues Certain permitted coverage expenses (i.e., vision/dental) Preventive care –Difficult administration issues

44. 44 Trap #4: Disqualifying Coverage Health FSA/HRA coverage (cont’) –Situations in which you can have HRA and still be an Eligible Individual HRA coverage is limited to: –Expenses incurred after statutory minimum deductible is met (Post deductible) –Permitted coverage expenses (e.g., vision, dental) –Premiums for permitted insurance policies (e.g., specified disease or fixed indemnity per diem) –Preventive care –Suspended HRA –Retiree only HRA

45. 45 Trap #4: Disqualifying Coverage Health FSA/HRA Coverage (cont’) –Dilemma regarding spouse’s health FSA coverage E.g., Employee A has single HDHP coverage but is also covered under spouse’s employer’s general purpose Health FSA. –Plan sponsors could implement “single” and “family” Health FSAs –Administrative difficulties –Qualifying HDHP that is FSA or HRA must be accompanied by HDHP major medical coverage I.e., High deductible Health FSA/HRA cannot be the only HDHP coverage –Health FSA Grace Period

46. 46 Trap #4: Disqualifying Coverage Health FSA Grace Period: –Notice 2005-86 if participant in general purpose Health FSA (w/ grace period) on last day of plan year (either active or COBRA qualified beneficiary), participant disqualified from HSA establishment until first day of first month following end of grace period EVEN IF ZERO BALANCE on last day of plan year or any time prior to end of grace period

47. 47 Trap #4: Disqualifying Coverage Health FSA Grace Period (cont’) –Example of Notice 2005-86 rule: Bob participates in calendar year Health FSA with 2 ½ month grace period ending March 15 of following year. Bob receives reimbursement for full election amount on December 15, 2007 so that he has $0 balance on December 31, 2007. Although Bob has $0 balance, Bob is not eligible for an HSA until April 1, 2008. –Only solution provided under Notice 2005-86 was to convert FSA during grace period to limited purpose FSA for ALL HEALTH FSA PARTICIPANTS

48. 48 Trap #4: Disqualifying Coverage Health FSA Grace Period (cont’) –New rule under HR 6111 Grace period does not disqualify an individual if individual has zero balance on last day of plan year –This can be accomplished in one of two ways: Spend funds down prior to end of the plan year Make the one time tax free rollover under applicable rules (see Trap #5)

49. 49 Trap #4: Disqualifying Coverage Health FSA Grace Period (cont’) –Good news: Provides relief from Notice 2005-86 impediment –Allows Bob to establish HSA on January 1, 2008 instead of April 1, 2008 –Bad news: Encourages end of year “unnecessary” spending (the very thing the grace period avoided)

50. 50 Trap #4: Disqualifying Coverage What about EAPs, wellness and disease management? –Participation in employee assistance programs (EAPs), wellness programs and disease management programs do not disqualify an otherwise eligible individual so long as the programs are not considered “health plans” for HSA purposes –Such a program is not a “health plan” if it does not provide significant benefits in the nature of medical care or treatment

51. 51 Trap #4: Disqualifying Coverage Permissible employee assistance plans –Coverage is limited to free or low cost short term counseling sessions on various issues including mental health, emotional disorders, and substance abuse –Refers to an outside organization when necessary EAP may be a “health plan” for purposes of COBRA or other laws but not a health plan for HSA purposes Impact of conditioning participation in EAP on participation in health plan?

52. 52 Trap #4: Disqualifying Coverage Permissible Disease Management Programs –Program typically provides only Disease specific education and information materials Care oversight and management (including care coordination)

53. 53 Trap #4: Disqualifying Coverage Permissible Wellness Programs –Program offers wide range of activities designed to improve the overall health of the employee and prevent illness, including but not limited to: Education Fitness Sports Stress management Health screenings –Any charge for such program is separate from the health plan –Impact of conditioning participation in wellness program on participation in health plan?

54. 54 HSA/HRA Traps and Pitfalls Trap #5: New Contribution Rules under HR 6111

55. 55 Trap #5: New Contribution Rules Four new contribution rules under HR 6111 –Revised Maximum Annual Contribution –Pro-rata Rule Exception –Rollover from Health FSA/HRA –Rollover from IRA

56. 56 Trap #5: New Contribution Rules Revised Maximum Contribution Amount –Prior rule Annual contribution amount is sum of “monthly limits” for each month individual is an eligible individual –Pro-rata rule Monthly limit equals 1/12 of “lesser of deductible” or statutory maximum for applicable level of coverage”

57. 57 Trap #5: New Contribution Rules Revised Maximum Contribution Amount (cont’) –Example of prior rule: –Bob (who is under age 55) is enrolled from January 1, 2007 through December 31, 2007 in an HDHP, single coverage, with a $1200 deductible. –Under old rule, Bob may only contribute $1200 in 2007 instead of $2850 (the statutory maximum for single coverage).

58. 58 Trap #5: New Contribution Rules Revised Maximum Contribution Amount (cont’) –New rule: Annual contribution amount is sum of “monthly limits” for each month individual is an eligible individual (same as old) Monthly limit equals 1/12 of statutory maximum for applicable level of coverage (i.e., single or family) WITHOUT REGARD TO HDHP DEDUCTIBLE –2850 for single –5650 for family

59. 59 Trap #5: New Contribution Rules Revised Maximum Contribution Amount (cont’) –Example of new rule: Bob (who is under age 55) is enrolled from January 1, 2007 through December 31, 2007 in an HDHP, single coverage, with a $1200 deductible. Under new rule, Bob may contribute $2850 in 2007 instead of $1200 (the maximum contribution amount under the prior rule). Contribution increase=$1650

60. 60 Trap #5: New Contribution Rules Revised Maximum Contribution Amount (cont’) –Good news (cont) Allows some employees to contribute more than deductible amount Eliminates complicated contribution calculation rules for –Plan’s with carry over deductible deductible must still meet adjusted minimum deductible rule –Plan’s with embedded deductible Embedded deductible must still meet family deductible minimum –Married couples who are eligible individuals

61. 61 Trap #5: New Contribution Rules Revised Maximum Contribution Amount (cont’) –Bad news Pro-rata rule not completely eliminated (but see special exception on next slides) Not valuable for those with deductible in excess of statutory maximum contribution amount

62. 62 Trap #5: New Contribution Rules Pro-rata exception rule –Prior Rule: Maximum contribution was “sum of monthly limits” based on # of months individual was eligible individual Deductible under plan typically not pro-rated, which caused gap between HSA contribution amount and participant responsibility

63. 63 Trap #5: New Contribution Rules Pro-rata exception rule (cont’) –Example of prior rule: Bob (who is under age 55) is enrolled from July 1, 2007 through December 31, 2007 in an HDHP, single coverage with a deductible of $3000. Bob’s monthly limit is $237.50 (1/12 of $2850). Bob is an eligible individual in 2007 for 6 months. Bob’s annual contribution amount for 2007 is $1425; however, Bob’s deductible is $3000 even though he is in the plan for only 6 months.

64. 64 Trap #5: New Contribution Rules Pro-rata exception rule (cont’) –New rule Pro-rata rule still applies EXCEPT: Individual is treated as being an eligible individual for the entire year If –individual is an eligible individual in December of such year and –the individual remains an eligible individual through December of the next year (“Testing Period”)

65. 65 Trap #5: New Contribution Rules Pro-rata exception rule (cont’) –New rule (cont) For months that individual was not an eligible individual, individual treated as having the coverage in effect in December of the year he/she became an eligible individual Applies to additional contribution for age 55+ accountholders Income and 10% excise tax if individual ceases to be an eligible individual during Testing Period:

66. 66 Trap #5: New Contribution Rules Pro-rata exception rule (cont’) –Example of new rule: Bob (who is under age 55) is enrolled from July 1, 2007 through December 31, 2007 in an HDHP, single coverage with a deductible of $3000. Bob’s remains eligible through December 31, 2008 Bob’s annual contribution amount for 2007 is $2850 (as opposed to $1500 under prior rule) If Bob ceases to be eligible during testing period, then $1425 (6/12 of $2850 for January through June) is included in income and subject to 10% excise tax

67. 67 Trap #5: New Contribution Rules Pro-rata exception rule (cont’) –Good News Reconciles traditional application of deductible with maximum contribution rules –Bad news Must remain eligible individual during Testing Period Does not apply unless eligible individual in December (i.e., covered by December 1 st ) of year

68. 68 Trap #5: New Contribution Rules IRA Distributions to HSA (Qualified HSA Funding Distributions) –Prior rule: IRA funds could not be transferred to HSA on a tax free basis –New Rule: One time tax free trustee to trustee transfer of IRA funds to HSA permitted Limited to maximum annual contribution amount –May make an additional contribution if you change from single to family during the year

69. 69 Trap #5: New Contribution Rules IRA Distributions to HSA (cont’) –New Rule (cont’) COUNTS AGAINST ANNUAL CONTRIBUTION AMOUNT Must remain Eligible Individual During Testing Period –The month in which distribution made and ending last day of 12 month following such month

70. 70 Trap #5: New Contribution Rules IRA Distributions to HSA (cont’) –Good News: Allows individuals to shift poor performing IRA funds to HSA without adverse tax consequences Allows individuals to use IRA funds to offset gaps between maximum contribution amount and employer contribution –Bad news: Must remain eligible individual during testing period Counts against annual contribution limit

71. 71 Trap #5: New Contribution Rules Health FSA/HRA Rollover (Qualified HSA Distribution) –Prior rule: HRA and/or Health FSA amounts could not be transferred to an HSA on a tax free basis –New rule: Employer may make one-time tax free transfer of “Applicable Balance” to HSA anytime before January 1, 2012 provided certain conditions are satisfied –Applies to Health FSA and HRA individually

72. 72 Trap #5: New Contribution Rules Health FSA/HRA Rollover (cont’) –New Rule (cont’) Applicable Balance=lesser of balance as of September 21, 2006 or balance as of the date the distribution is made Only available to those who had a balance on September 21, 2006 “Balance” does not include expenses incurred prior to distribution but not yet reimbursed

73. 73 Trap #5: New Contribution Rules Health FSA/HRA Rollover (cont’) –New rule (cont) Treated as a rollover contribution (thus, not counted against maximum annual contribution amount) Must remain eligible individual during Testing Period –The month in which distribution made and ending last day of 12 month following such month

74. 74 Trap #5: New Contribution Rules Notice 2007-22--Permanent and Transition Guidance regarding Health FSA/HRA rollovers –Permanent guidance: An employee with a balance in a general purpose FSA with a grace period or general purpose HRA at the end of a plan year is treated as an eligible individual for HSA purposes as of the first day of the first month of the immediately following plan year provided that the following conditions are satisfied:

75. 75 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Permanent Rules--Conditions the employer amends the health FSA or HRA written plan effective by the last day of the plan year to allow a qualified HSA distribution; a qualified HSA distribution from the health FSA or HRA has not been previously made on behalf of the employee with respect to that particular health FSA or HRA; the employee has HDHP coverage as of the first day of the month during which the qualified HSA distribution occurs, and is otherwise an eligible individual;

76. 76 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Permanent Rules--Conditions the employee elects by the last day of the plan year to have the employer make a qualified HSA distribution from the health FSA or HRA to the HSA of the employee; the health FSA or HRA makes no reimbursements to the employee after the last day of the plan year; the employer makes the qualified HSA distribution directly to the HSA trustee by the fifteenth day of the third calendar month following the end of the immediately preceding plan year, but after the employee becomes HSA-eligible;

77. 77 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Permanent Rules—Conditions the qualified HSA distribution from the health FSA or HRA does not exceed the lesser of the balance of the health FSA or HRA on (a) September 21, 2006, or (b) the date of the distribution; and after the qualified HSA distribution there is a zero balance in the health FSA or HRA, and the employee is no longer a participant in any non-HSA compatible health plan or (b) effective on or before the date of the first qualified HSA distribution the general purpose health FSA or general purpose HRA written plan is converted to an HSA-compatible health FSA or HRA, as described in Rev. Rul. 2004-45, for all participants.

78. 78 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Transition Rule: an employee with a balance in a general purpose FSA with a grace period or general purpose HRA after December 31, 2006 is treated as an eligible individual for HSA purposes as of the first day of the first month in 2007 provided that the following conditions are satisfied:

79. 79 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Transition Rule--conditions: the employer amends the health FSA or HRA written plan effective on or before March 15, 2007, to allow a qualified HSA distribution; a qualified HSA distribution from the health FSA or HRA has not been previously made on behalf of the employee with respect to that particular health FSA or HRA; the employee has HDHP coverage as of the first day of the month during which the qualified HSA distribution occurs, and is otherwise an eligible individual;

80. 80 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Transition Guidance-conditions (cont) the employee elects on or before March 15, 2007, to have the employer make a qualified HSA distribution from the health FSA or HRA to the HSA of the employee; the qualified HSA distribution from the health FSA or HRA does not exceed the lesser of the balance of the respective health FSA or HRA on (a) September 21, 2006, or (b) the date of the distribution;

81. 81 Trap #5: New Contribution Rules Notice 2007-22 Permanent and Transition Guidance regarding Health FSA/HRA rollovers (cont’) –Transition Guidance –conditions (cont) the employer makes the qualified HSA distribution directly to the HSA trustee by March 15, 2007, but after the employee becomes HSA-eligible; and after the qualified HSA distribution there is a zero balance in the health FSA or HRA, and the employee is no longer a participant in any non-HSA compatible health plan or (b) effective on or before the date of the first qualified HSA distribution, the general purpose health FSA or general purpose HRA written plan is converted to an HSA-compatible health FSA or HRA, as described in Rev. Rul. 2004-45, for all participants.

82. 82 Trap #5: New Contribution Rules Example of new rule: –Bob has $500 balance on September 21, 2006. –On December 31, 2008, Bob has a $300 balance in his Health FSA (with a grace period). Bob wants to enroll in HDHP and establish an HSA on January 1, 2009 but Health FSA is general purpose. –Bob’s employer may transfer $300 to Bob’s HSA on December 31.

83. 83 Trap #5: New Contribution Rules Good News: –Does not count against the maximum annual contribution amount

84. 84 Trap #5: New Contribution Rules Bad News: –Must remain eligible individual during Testing Period –Requires employer/plan sponsors and/or administrators to maintain records of balance on September 21, 2006 –Confusing to communicate to participants –Problems if current balance is greater than balance as of September 21, 2006 Assume Bob had $1000 on August 1, 2008 instead of $300 –Not valuable to those who did not have Health FSA or HRA on September 21, 2006 –ONLY APPLIES TO HEALTH FSAS WITH GRACE PERIOD

85. 85 HSA/HRA Pitfalls Trap #6: Distribution Traps

86. 86 Trap #6: Distribution Traps Impact of timing of HSA establishment on eligible expenses –HSA must be established BEFORE medical expenses are incurred –Notice 2007-22 State trust law governs Many states indicate no trust exists until there is a corpus (i.e. contributions) Withdrawing funds before/in excess of eligible expenses –Repricing dilemma and putting funds back in an HSA –Can expenses and distributions be “netted” ? –Year-end traps

87. 87 HSA/HRA Traps and Pitfalls Trap #7: Cafeteria Plan Issues

88. 88 Trap #7: Cafeteria Plan Issues What cafeteria plan rules apply? –Code Section 125 non-discrimination rules –Modified election rules apply HSA salary reduction election may be changed at any time for any reason IRS has informally indicated that monthly election changes MUST be allowed Cafeteria plan election allowed mid year to add HSA –Changes to other benefits (such as Health FSA) only permitted if otherwise allowed under Section 125 (or the plan) Negative elections permitted

89. 89 HSA/HRA Traps and Pitfalls Trap #8: Prohibited Transaction Issues

90. 90 Trap #8: Prohibited Transaction Rules Tax Code (as well as ERISA) prohibits most transactions between a plan (i.e., the HSA) and a disqualified person (e.g., any HSA service provider) 2 types of PTs: –4975 PTs Can be committed by account holder, custodian, trustee, or other vendor 100% excise tax on amount involved if committed by other than account holder HSA disqualification if committed by account holder and all amounts treated as improper distribution subject to income and 10% excise tax –408 Impermissible Security for a loan HSA amount used as security/collateral for a loan is treated as improper distribution subject to income and 10% excise tax

91. 91 Trap #8: Prohibited Transaction Rules What are the areas that might constitute a Prohibited Transaction in the HSA context: –Unreasonable fees to service provider Accountholder must determine if reasonable –Hidden or unusual fees received by service provider 12b-1 Interchange from card –All HSA Vendors must disclose

92. 92 Trap #8: Prohibited Transaction Rules What are the areas that might constitute a Prohibited Transaction in the HSA context (cont’): –Extension of credit/overdraft See DOL. Adv. Op. 2002-03 See also FAB 2006-02 –Depends on Facts and Circumstances –See toaster rulings in Dol Adv. Op. 89-12/PTE 93- 33 – Receipt of personal compensation to account holder as incentive to enroll or invest See DOL. Adv. Op. 2004-09A See toaster rulings in Dol Adv. Op. 89-12/PTE 93-33

93. 93 HSA/HRA Traps and Pitfalls Trap #9: Employee Cash Flow Concerns

94. 94 Trap #9: Employee Cash-flow Concerns HSA funds generally only available once deposited Coverage can be “accelerated” under cafeteria plan –Employer may advance amounts up to employee’s salary reduction amount so long as the following conditions are satisfied: Advances equally available to all other participants Employee repays employer HSA-related loans –HSA cannot be security (deemed distribution) –Extension of credit (see PT slides)

95. 95 HSA/HRA Traps and Pitfalls Trap #10: Monitoring of Contribution Amounts

96. 96 Trap #10: Monitoring of Contribution Amounts Who is responsible for monitoring contribution amounts? –Account holder is ultimately responsible Does employer have any responsibility? –If it makes contributions, it must ensure that: If employee has HDHP coverage with employer, the HDHP coverage qualifies That employee has no other coverage SPONSORED BY EMPLOYER that is disqualifying coverage Outside coverage not an issue for employer –Failure to monitor can result in withholding liability on amounts included in income Does Trustee have any responsibility? –To ensure that contributions do not exceed family statutory maximum (plus catch up) WITHOUT REGARD TO ACTUAL LEVEL OF COVERAGE I.e. cant allow more than $5650 plus 800 in 2007 –Must monitor age

97. 97 Other Compliance Concerns HIPAA Privacy COBRA and HSAs Federal Tax Reporting –Helpful guidance in Form 969 –HSA Participant Must File Form 1040 (1040A and 1040EZ not allowed) Form 8889 –Trustee/custodians Form 5498 Form 1099-SA State income and employment tax requirements