In our December 2006 Legal Alert, we described the passage of the Tax Relief and Health Care Act of 2006 (the “Act”), which significantly enhanced the features of Health Savings Accounts (“HSAs”). One of these enhancements was the ability to make a rollover from a health flexible spending account (a “health FSA”) or from a health reimbursement arrangement (“HRA”) to an HSA. The Internal Revenue Service has now issued Notice 2007-22 (the “Notice”) providing guidance on these rollovers. The Notice also provides special transition relief for rollovers that are completed before March 15, 2007.

Background

To be an eligible individual who is permitted to contribute to an HSA for a particular month, the individual must (1) be covered by a high deductible health plan (“HDHP”) as of the first day of the month, and (2) not be covered by any other health plan (with the exception of certain disregarded coverage and permitted insurance). An individual covered by a general purpose health FSA or HRA does not satisfy this requirement. Further, if a general purpose health FSA allows an individual to be reimbursed for expenses incurred during a grace period following the end of the year, an individual generally will not be an eligible individual for HSA purposes until the first day of the month that follows the end of the grace period (.e.g., April 1, in the case of a maximum grace period that ends on March 15). However, the Act made two important modifications to this rule. First, the Act provided that an employee with a zero balance on December 31st in a health FSA is not disqualified from establishing or contributing to an HSA during the health FSA’s grace period. Second, the grace period rule will also not disqualify an employee from participating in an HSA as of January 1st, if the employer rolls over the balance remaining in the employee’s health FSA account at the end of the plan year to an HSA (referred to as a “Qualified HSA Distribution”).

A Qualified HSA Distribution is a one-time rollover by an employer from a health FSA or HRA to an HSA that is completed prior to January 1, 2012. The rollover amount must not exceed the lesser of the balance in the health FSA or HRA on September 21, 2006 or the balance on the date of the rollover. This amount is treated as a rollover to the HSA, and therefore it does not reduce the annual maximum HSA contribution for the year the rollover is made. An individual for whom a rollover is made must continue to be enrolled in an HDHP for a 12-month period beginning with the month in which the rollover is contributed to the HSA. If the individual is not so enrolled (except by reason of death or disability), then the entire amount of the rollover is included in the individual’s taxable income and is subject to a 10% penalty tax. Further, if an employer desires to allow rollovers, it must make rollovers available to all employees covered under the employer’s HDHP. (Note: This is a different approach than under the comparability rules for nondiscrimination with respect to HSA employer contributions, where comparability can sometimes require benefiting those who are in an HDHP that is not the employer’s.)

IRS Notice 2007-22

The Notice outlines the general rules of a Qualified HSA Distribution under the Act, provides specific additional rules to follow for Qualified HSA Distributions (including a transition rule for 2007), and discusses other special issues related to Qualified HSA Distributions.

Summary of Requirements.

The Notice provides that an employee with a balance in a general purpose health FSA with a grace period or in a general purpose HRA at the end of the plan year can participate in an HSA as of the first day of the month following the end of that plan year, if all of the following requirements are met:

  • The employer amends the plan effective by the last day of the plan year to allow a Qualified HSA Distribution.
  • A Qualified HSA Distribution has not previously been made for that employee with respect to that FSA or HRA.
  • The employee has HDHP coverage as of the first day of the month during with the distribution occurs, and is otherwise an eligible individual.
  • The employee elects by the last day of the plan year to have the employer make a Qualified HSA Distribution.
  • The health FSA or HRA makes no reimbursements to the employee after the last day of the plan year. (Note, that this appears to prevent the use of a claims run-out period.)
  • The employer makes the distribution directly to the HSA trustee by the fifteenth day of the third calendar month following the end of the plan year (March 15 for calendar year plans), but after the employee becomes HSA eligible.
  • The distribution does not exceed the lesser of the balance of the health FSA or HRA account on September 21, 2006 or the balance on the date of the distribution.
  • After the 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 before the first day of the eligible distribution, the general purpose health FSA or HRA is converted to an HSA-compatible plan for all participants.

Transition Rule for 2006 Balances.

A transition rule is provided for Qualified HSA Distributions made before March 15, 2007. Under this rule, an employee with a balance in a general purpose health FSA or HRA after December 31, 2006, is treated as an eligible individual for HSA purposes as of the first day of a month in 2007, if all of the following requirements are met:

  • The employer amends the plan effective on or before March 15, 2007, to allow a Qualified HSA Distribution.
  • A Qualified HSA Distribution has not previously been made for that employee with respect to that FSA or HRA.
  • The employee has HDHP coverage as of the first day of the month during with the distribution occurs, and is otherwise an eligible individual.
  • The employee elects on or before March 15, 2007 to have the employer make a Qualified HSA Distribution.
  • The employer makes the distribution directly to the HSA trustee by March 15, 2007, but after the employee becomes HSA eligible.
  • The distribution does not exceed the lesser of the balance of the health FSA or HRA account on September 21, 2006 or the balance on the date of the distribution.
  • After the 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 effective on or before the date of the first qualified distribution, the general purpose health FSA or HRA is converted to an HSA-compatible plan for all participants.

Note, that under the 2006 transition rule, reimbursements of qualifying expenses that have occurred prior to March 15, 2007 from the health FSA (based on the grace period) or from an HRA will not disqualify the rollover from being a Qualified HSA Distribution. However, the Qualified HSA Distribution must be made by March 15, 2007 and must equal the remaining balance in the health FSA or HRA on the date of the distribution or the balance on September 21, 2006, if less.

Transition Example.

Assume that an employer, who has a general purpose health FSA in 2006 with a grace period that ends on March 15, 2007, allows employees to elect coverage under an HDHP effective January 1, 2007. The employer amends the health FSA to permit Qualified HSA Distributions. Under these facts, with respect to three employees who elect HDHP coverage effective January 1, 2007:

Employee A has a balance of $1,000 on September 21, 2006 and $900 on December 31, 2006, incurs a medical expense for $900 in January 2007, is reimbursed for $900 in January 2007, but does not elect a Qualified HSA Distribution. In this situation, Employee A is not an eligible individual for the HSA until April 1, 2007, because the employee did not have a zero balance on December 31, 2006, or following a qualified distribution on or before March 15, 2007.

Employee B has a balance of $900 on September 21, 2006 and $800 on December 31, 2006, incurs a medical expense for $50 in January 2007, is reimbursed for $50 in January 2007, and elects to have a qualified distribution made to an HSA in February 2007 of the $750 remaining account balance. This employee is an eligible individual as of January 1, 2007, because the qualified distribution occurred before March 15, 2007, and after the distribution the employee is covered under an HDHP and has a zero account balance in the health FSA. (Note, but for the transition relief, this employee would not be an eligible individual as of January 1, 2007, because the FSA made reimbursements during the grace period and the employee did not elect the qualified distribution prior to the end of the plan year.

Employee C has a balance of $5,000 on September 21, 2006 and $100 on December 31, 2006, and has an incurred but not submitted medical expense for $100 on December 31, 2006. Incurred but unreimbursed claims are not considered in determining the account balance. Thus, this employee is not otherwise HSA-eligible on January 1, 2007, because the account balance is not zero. Employee C must decide whether to use the employee’s one-time rollover opportunity now to obtain HSA eligibility retroactive to January 1, 2007 or to save the rollover right for a future year and wait until April 1, 2007 to be HSA-eligible. Employee C may desire to save the rollover right, because the rollover would only be $100 and Employee C could rollover a potentially larger amount (up to $5,000 due to the September 21, 2006 balance) from a different health FSA in the future (e.g., from a limited-purpose health FSA).

Special Issues. The Notice also discusses certain special issues that employers should keep in mind when deciding to make a rollover from a health FSA or HRA to an HSA. These special issues include the following:

  • Forfeiture of Unused FSA Amounts.The Notice does not change the requirement that unused amounts remaining in a health FSA be forfeited at the end of the plan year (or at the end of any applicable grace period). If a health FSA does not have a grace period, these unused amounts cannot be transferred through a Qualified HSA Distribution after the end of the plan year. (Note: Although unused amounts can be distributed to an HSA mid-year, because the health FSA coverage continues until the end of the plan year, an individual covered by the health FSA is not an eligible individual after a mid-year distribution, thereby requiring the inclusion of the distribution in income, plus the additional 10% penalty tax.) For this reason, a Qualified HSA Distribution should only be performed at the end of a plan year.
  • Cash Basis Balances .All balances must be determined on a cash basis. This means that expenses that have been incurred but not reimbursed as of a particular date are not taken into account and neither are pending claims or claims under review. For the health FSA, the balance is determined using the full amount of the account that is available for reimbursement (that is, the full amount elected for the year) reduced for any reimbursements paid as of the date of the distribution. (See, employee C in the example above.)
  • Zero Balance Rule .Under the Act, if an individual has a zero balance on the last day of the plan year, determined on a cash basis, the individual will not fail to be an eligible individual as of the first day of the next year because of coverage during a general purpose health FSA grace period. The Notice then provides that if an individual has a zero balance in a general purpose HRA on the last day of the HRA plan year, determined on a cash basis, the individual will not fail to be an eligible individual as of the first day of the next HRA plan year, if (1) the employee waives participation in the general purpose HRA, (2) the employer terminates the HRA with respect to all employees, or (3) the employer converts the general purpose HRA to an HSA-compatible HRA.
  • Date of HDHP Coverage. The Notice emphasizes that if an individual begins HDHP coverage after the first day of a month, that individual is not an eligible individual for the HSA until the first day of the next month. Therefore, Qualified HSA Distributions would have to made on or after the first day of that next month to be excludable from income.
  • Additional Tax During Testing Period. If an individual ceases to be an eligible individual during the testing period (i.e., the 12-month period beginning with the month in which the rollover is contributed to the HSA), the amount of the Qualified HSA Distribution is included in taxable income and subject to an additional 10% penalty tax. However, the Notice clarifies that this result does not require the withdrawal of the distribution, and the amount of the distribution is also not treated as an excess contribution. 
  • Limited Employer Reporting. The Notice provides that Qualified HSA Distributions are not reported on an employee’s Form W-2, but that the employer is required to report the distribution to the HSA trustee. The HSA trustee is then required to report the distribution as a rollover contribution on Form 5498-SA. Further, the Notice also provides that employers are not required to report whether an employee receiving a Qualified HSA Distribution remains an eligible individual during the testing period.