Health reimbursement arrangements get clearance from the IRS.

The Treasury Department and IRS have issued guidance that clarifies the tax treatment of health reimbursement arrangements (HRAs) in which the employer's health benefit arrangement provides for employee-controlled reimbursement of medical costs [Notice 2002-45; IRB 2002-28, 7/15/02]. "With this new guidance," stated Treasury Secretary Paul O'Neill, "we clear the way for employers to adopt health plans with patient-directed features so that employees have more choice and greater control over their health care coverage."

The guidance explains that medical benefits paid by HRAs that meet certain requirements can be excluded from an employee's income. The primary requirements are that the health reimbursement arrangement must ...

1. provide benefits only for substantiated medical expenses, and

2. be funded solely by the employer and cannot be funded by salary reduction.

What does this mean to you? Since HRAs are not funded through salary reductions, you may think these arrangements are of no concern to Payroll. But the fact is that imbedded in the guidelines for HRAs are some rather unique compliance risks. For one thing, HRAs (which resemble hybrid defined contribution plan/flexible spending accounts) can be offered alongside more familiar arrangements. And the way arrangements such as cafeteria plans and flexible spending accounts--and even bonuses and severance pay--are administered can eliminate the income exclusion benefit of an HRA.

The big risk. One misstep does more than cause one reimbursement to one employee to become taxable. A single incident of noncompliance could mean all the HRA reimbursements for the entire year would have to be added to employees' income.

With that in mind, let's take a look at the general guidance provided in Notice 2002-45.

Tax Treatment of HRAs

To the extent that an HRA is an employer-provided accident or health plan, coverage and reimbursements of medical care expenses of an employee and the employee's spouse and dependents are generally excludable from the employee's gross income. However, an HRA will not qualify for the income exclusion if any person has the right to receive cash or any other taxable or nontaxable benefit under …