Current Developments in Employee Benefits and Pensions (Part I)

By Deborah Walker, CPA; Mark Neilio, J.D.; and Michael Haberman, J.D., LL.M.


  • Notice 2007-100 provides relief for limited unintentional Sec. 409A operational failures, including early payments and failed deferrals, failures to delay distribution of deferred compensation, and excess deferrals.
  • The IRS issued proposed regulations addressing issues related to the interplay of the qualified plan qualification rules in Sec. 401 and the health care related exclusions from income in Secs. 104–106.
  • The IRS provided HSA guidance in final regulations on the comparable contribution requirements for employee HSAs and two notices that addressed the full contribution rule for HSAs and a variety of other HSA issues.

This two-part article covers significant developments in late 2007 and 2008 in employee benefits, including executive compensation, welfare benefits, and qualified plans. Part I, below, focuses on new guidance regarding executive compensation and welfare benefits. Part II, in the December 2008 issue, will focus on updates and changes to the rules for qualified retirement plans.

Sec. 409A

Though Sec. 409A was signed into law in 2004,1 the IRS continues to issue guidance to ease the burden of complying with the new nonqualified deferred compensation (NQDC) rules. Over the past year, the IRS has released several noteworthy pieces of guidance.
Sec. 409A Transitional Guidance
Beginning on January 1, 2009, taxpayers are required to comply with the Sec. 409A final regulations, which were released in April 2007. Until then, taxpayers must operate an NQDC plan in compliance with the plan's terms, to the extent consistent with Sec. 409A and applicable IRS guidance (including Notice 2005-1 and other notices). 2 Where a provision of Notice 2005-1 is inconsistent with the final regulations, taxpayers may rely on either Notice 2005-1 or the final regulations, but generally may not rely on the proposed regulations after December 31, 2007. 3

In October 2007, the IRS released Notice 2007-864 to extend transition relief until January 1, 2009, in the following areas:

  • The deadline for a plan to allow the selection of the time and form of payment; 5
  • The ability for taxpayers to "reform" options by making the exercise price equal to the fair market value of the underlying share at exercise (thus exempting them from the Sec. 409A rules); 6
  • The deadline for Sec. 409A compliance for NQDC plans linked to qualified plans; and
  • The transition rule that requires income inclusion in the year following the year in which a violation occurs. Thus, if no corrective action is taken by the end of 2008, violations will first be reported in 2009. 7
Some taxpayers are using this transition to accelerate income into early 2009 in hopes of avoiding increased taxes in the future. Whether this is a good idea or not depends on future tax rates and the current schedule of payments. In no event can a payment be moved into 2008.
Correction Program for Sec. 409A Operational Failures
Acknowledging the requests of practitioners nationwide, in December 2007 the IRS issued Notice 2007-100,8 providing narrow relief for limited Sec. 409A operational failures. Notice 2007-100 addresses the correction of operational errors made during the same tax year and correction of certain de minimis operational failures in the year following the year of the failure. Exercise of a discounted stock right results in a failure under Sec. 409A and is specifically excluded from correction.

The relief provided by Notice 2007-100 is in addition to adjustments or corrections that may be available under current transition relief, which is generally scheduled to expire on December 31, 2008. In addition, Notice 2007-100 includes an extensive request for comments on a potential correction program. Moreover, while Notice 2007-100 may be helpful to some taxpayers under limited circumstances during the transition period, its greater significance is as a first step toward a post-transition relief correction program.

Basic requirements:A service recipient can only rely on Notice 2007-100 if it meets certain basic eligibility requirements. The failure must be an unintentional failure to (1) comply with plan provisions that conform to Sec. 409A or (2) follow Sec. 409A in practice due to inadvertent errors in plan operation. The failure cannot be egregious or related to participation in a "listed transaction" under Regs. Sec. 1.6011-4(b)(2).

The service recipient must take commercially reasonable steps to avoid recurrence of the failure. If the same or a substantially similar failure has happened before, relief is available after December 31, 2008, only if the service recipient had subsequent to the initial failure established practices and procedures reasonably designed to ensure that the failure would not recur and had taken commercially reasonable steps to avoid recurrence. In addition, the service provider's annual income tax return cannot be under examination for the year of failure. Finally, certain corrections for erroneous payments are not available during tax years in which the service recipient experiences a substantial financial downturn or displays other indicia of a significant risk that the service recipient would not be able to pay the amount deferred when due. 9

Taxpayers who rely on Notice 2007- 100 have the burden of showing that they satisfy its requirements, and the application of the notice is subject to IRS examination. Toward these ends, Notice 2007-100 requires certain reporting and disclosure requirements. 10

Correcting failures within the service provider's tax year: If the service provider meets the eligibility requirements, it may be able to correct certain unintentional operational failures during the service provider's tax year in which such failures occur. The allowable correction method depends on the type of failure, and Notice 2007-100 identifies the following types of correctable failures:

  • Early payments and failed deferrals: In general, early payments (amounts deferred in a prior year that should be paid in a future year but are mistakenly paid or made available during the current year) and failed deferrals (amounts otherwise payable in the current year that should have been deferred to a future year but are mistakenly paid or made available during the current year) can be repaid to the service recipient and treated as having been timely deferred or continuing to be deferred. Repayment can occur by actual payment or by withholding from future payments, as long as it is completed by the end of the service provider's tax year.
  • Failure to delay distribution of deferred compensation on separation from service: Where amounts have mistakenly been paid or made available to specified employees within six months after separation from service, the service provider must not only repay the amount but must also wait additional time—equal to the number of days it held the mistaken payment—after the original sixmonth period expires before it can receive payment. Notice 2007-100 seems to require actual repayment rather than withholding from other payments.
  • Excess deferrals: Notice 2007-100 also provides a specific correction related to a mistake in retaining amounts that were not subject to a deferral election if the amounts are distributed by the end of the service provider's current tax year. This rule does not apply to amounts deferred in the service provider's prior tax years.
If the service provider is an insider,11 its account balance or benefit must be adjusted for any positive earnings attributable to the mistaken deferral. For noninsiders, an adjustment for earnings or losses is optional. In any case, any adjustment generally must be made by the end of the service provider's tax year, but if that is impracticable and the service provider and service recipient each have a legally binding right with respect to the adjustment as of that date, it may be made later, retroactive to that date. The service recipient may pay reasonable interest to the service provider for the use of its money, as long as it is paid or made available by the end of the service provider's tax year.

Methods for limiting taxes after the service provider's tax year: If an unintentional operational failure is not corrected by the end of the service provider's tax year in which it occurs, Notice 2007-100 does not allow the service provider to avoid tax under Sec. 409A(a) by correcting the failure; however, if certain additional requirements are met, the amount of tax the service provider owes may be limited to ordinary income taxes and the 20% additional tax under Sec. 409A(a)(1)(B)(i)(II) on the amount of the failure. Other amounts deferred under the plan or under similar plans are not currently taxed, and the interest penalty tax under Sec. 409A(a)(1)(B)(i)(I) does not apply. 12

Conclusion: Notice 2007-100 is an important first step that taxpayers can use in certain specific situations. It is less important in 2008, the last transition year in which good-faith compliance is sufficient, but will be increasingly important as the regulations take effect and taxpayers unwittingly continue to violate these rules. The IRS is already examining these issues, and this will become even more prevalent in future years.

Further Clarification of Sec. 409A
Notice 2007-7813 clarifies the operation of Sec. 409A on several points. The first concerns the operation of a substitution rule that helps determine whether a right is grandfathered or is a new right. If a right to deferred compensation payable only upon an involuntary separation from service under an employment agreement is automatically forfeited at the end of the employment agreement's term, the grant of a right to deferred compensation in an extended, renewed, or renegotiated employment agreement will not be treated as a substitute for the forfeited right but will be considered a new right subject to Sec. 409A.

Notice 2007-78 also provides that a specific type of cashout provision (one based on a payout when the present value of remaining payments falls below a threshold) can be part of an "objectively determinable and nondiscretionary payment schedule" (required to comply with Sec. 409A's distribution rules) if the payment schedule would otherwise meet Sec. 409A rules and if it can be demonstrated that the provision operates in an objective, nondiscretionary manner that does not provide the service recipient or service provider with the effect of a late election. In addition, this provision can be used in conjunction with an installment payment or annuity without violating the substantially equal payment rule14 by ignoring any lump-sum cashout threshold. This provision facilitates the payout of small balances.

Finally, Notice 2007-78 provides limited relief from documentation requirements that a plan have a written provision regarding the mandatory delay in post-termination payments to "specified employees." In general, under final regulations, these provisions have to be adopted prior to the time any payment would need to be made to the specified individual.

Sec. 162(m) Changes

IRS Position on Sec. 162(m)
Under Regs. Sec. 1.162-27(e)(2)(v), performance-based compensation (compensation not subject to the $1 million deduction limit) may be paid prior to attaining the performance goals upon death, disability, or change of ownership or control. Letter rulings over the past decade15 had expanded the permissible early payment events to include payments on account of involuntary termination, termination for good reason, and retirement.

In Letter Ruling 200804004, released on January 25, 2008, the IRS departed from these previous letter rulings and held that possible payment under events not specifically mentioned in the regulations will result in a plan's failing to meet the performance- based compensation exception because amounts are not payable solely on the attainment of performance goals. Therefore, compensation paid under plans with these provisions is subject to the Sec. 162(m) deduction disallowance even if the performance goals were satisfied. This letter ruling was the subject of intense discussions with the IRS and Treasury in which taxpayers requested relief from this changed position. In response, the IRS issued

Rev. Rul. 2008-1316 to formalize its position on this issue and provide relief for certain existing arrangements. Rev. Rul. 2008-13 deals with a publicly held corporation's bonus plan that pays cash awards to employees if the corporation's earnings per share do not decrease during the calendar year. While the plan meets the other requirements to provide qualified performance-based compensation, it permits payment even if the employee does not attain the goal if the employee (1) is terminated without cause or voluntarily terminates employment for good reason or (2) voluntarily retires during the performance period. Given the permissible payment under these events, the compensation is not qualified performance- based compensation, and compensation paid under the plan is subject to Sec. 162(m) disallowance.

The ruling provides transition relief— compensation paid under any employment arrangement effective on February 21, 2008 (not taking into account extensions or renewals) and compensation paid for performance periods beginning on or before January 1, 2009, will not be subject to the revised rules. Taxpayers need to review their plans carefully, making the necessary changes to protect these compensation deductions before the transition time expires. However, this is favorable transition relief giving everyone time to continue adopting plans with these provisions for another year.

Sec. 162(m) Compensation Committee Rules
The performance-based compensation exception to the $1 million deduction limitation requires, in part, that the compensation committee that establishes and approves performance-based pay awards consists of two or more outside directors. To qualify as an outside director, a director cannot be—among other things—a former officer of the publicly held corporation. 17

On June 16, 2008, the IRS released Rev. Rul. 2008-32,18 holding that a former interim CEO was an officer of the publicly held corporation and thus did not qualify as an outside director for purposes of the exception. In reaching this conclusion, the ruling placed particular significance on the following facts: (1) although the individual's appointment was temporary, the interim CEO's authority was not limited in scope and (2) he was in continuous regular service, as opposed to being retained for a special and single transaction.

Information Return Requirement for Certain ESPP and ISO Stock Transfers

Under Sec. 6039, a corporation that transfers stock to an employee (or former employee) upon the exercise of an incentive stock option (ISO), as defined in Sec. 422(b), must give the employee an annual statement with regard to that transfer. 19 A similar requirement applies to stock received upon the exercise of an option granted under an employee stock purchase plan (ESPP), as defined in Sec. 423(b), if the option provides for a discounted exercise price. In the case of the ESPP, the employer must provide the annual statement when the employee sells or otherwise transfers the shares, rather than upon acquisition of the stock. 20
Information Return
The Tax Relief and Health Care Act of 200621 amended Sec. 6039 to require employers to file an information return with the IRS for stock transfers covered by Sec. 6039. This requirement was initially effective for stock transfers occurring on or after January 1, 2007, but required the issuance of regulations to clarify the actual requirement.

The IRS, recognizing that the regulations were not published in time for the statutory effective date, issued Notice 2008-8,22 which waived the filing requirement for information returns reporting stock transfers in 2007. In accordance with Notice 2008-8, statements to employees were still required for 2007; only the governmental reporting requirement was waived.

Subsequently, the IRS published proposed regulations under Sec. 6039 that delay the reporting requirements again. 23 As a result, employers are only required to furnish disclosure statements to employees, under existing regulations, for Sec. 6039 stock transfers for 2008. Beginning January 1, 2009, a stock transfer covered by Sec. 6039 will carry with it the new government reporting requirement, in addition to the requirement to give employees a statement to facilitate the preparation of their income tax return. Information reporting penalties apply to taxpayers who fail to comply.

The proposed regulations slightly alter the information currently required for transfers resulting from the exercise of an ISO, which will be reported on Form 3321, Exercise of an Incentive Stock Option Under Section 422(b). Under the proposed regulations, Form 3321 will require the employer to report the exercise price per share in lieu of the total cost of all shares acquired (the disclosure requirement within the existing regulations).

To satisfy the written statement requirement, employers will provide Form 3321 or 3322 (relating to transfers of shares acquired under an ESPP) to employees and the IRS. The deadline to report stock transfers and furnish the same to employees will remain January 31 following the year in which the transfer occurred; extensions of this deadline are available.

Ability of S Corporation 2% Shareholders to Deduct Health Premiums

Sec. 162(l) allows a taxpayer who is a 2% shareholder-employee in an S corporation to deduct premiums paid during the tax year to provide health insurance for the taxpayer and his or her spouse or dependent(s). The deduction may not exceed the taxpayer's earned income from the S corporation for the tax year, and no deduction is allowed for amounts paid for any calendar month in which the taxpayer is eligible to participate in any subsidized health plan maintained by an employer of the taxpayer or spouse.

In order for the taxpayer to deduct the premium, the S corporation must report the premium as wages on the taxpayer's Form W-2, and the taxpayer must report the premiums as gross income on Form 1040 for the tax year.

In 1991, the IRS ruled that the medical insurance must be "paid or furnished by" or established by the S corporation in order for the deduction under Sec. 162(l) to be available. 24 The exact parameters of this requirement were unclear. For example, there was uncertainty regarding the treatment if the policy at issue was purchased, or the policy premium was paid by the 2% shareholder-employee of the S corporation.

Notice 2008-1,25 issued on December 13, 2007, clarified that either of the following approaches will satisfy the requirement that the medical insurance must be paid, furnished, or established by the S corporation:

  • Payment by S corporation: The S corporation itself makes the premium payments for health insurance during the tax year.
  • Payment by employee and reimbursement by S corporation: The 2% shareholder- employee makes the premium payments for health insurance and furnishes proof of payment to the S corporation; the S corporation reimburses the 2% shareholder-employee for the premium payment during the tax year. 26
Taxpayers who were eligible but did not claim deductions under Sec. 162(l) may file timely amended tax returns to claim the deduction if they satisfy the requirements.

Tax Treatment of Qualified Plan Distributions Used to Pay Health Insurance Premiums

In late August 2007, the IRS proposed regulations relating to questions left open as a result of the interplay between Sec. 401 (qualified plan qualification) and Secs. 104–106 (health care–related exclusions from income). 27 The general rule is that distributions from qualified pension plans used to pay a distributee's health insurance premiums are taxed in the year of distribution. That is, the tax treatment of these distributions is governed by Secs. 402(a) and 72, not the Sec. 106 gross income exclusion for employer-provided health coverage. However, any benefits paid by the health plan will not be included in the participant's gross income under Sec. 104(a)(3).

Similarly, where a qualified defined contribution plan pays the premiums from amounts that have not yet been allocated to participants' accounts, the proposed regulations indicate that each participant's premium would be treated as first being allocated to his or her account and then charged against his or her benefit. 28 Thus, the amount of the premium payment will be treated as a taxable distribution to the participant, and any subsequent benefit payments by the health plan will not be taxed.

A corollary to the general rule is that employers may not allow retirees to use a Sec. 125 cafeteria plan to "salary reduce" their qualified plan distributions to pay health insurance premiums on a tax-favored basis. This is consistent with the proposed cafeteria plan regulations released in August 2007.

The proposed regulations include two exceptions to the general rule that distributions from qualified plans used to pay health insurance premiums are taxable in the year of distribution:

  • Qualified plans can include separate Sec. 401(h) accounts used to fund medical benefits for retirees and their spouses and dependents; and
  • Certain retired "public safety officers" can elect to exclude from gross income up to $3,000 per year of their governmental pension plan distributions directly paid to an insurer for health insurance or qualified long-term care insurance for the retiree and his or her spouse and dependents.
Under existing regulations, profit-sharing plans are permitted to provide incidental life or health insurance benefits for participants and their families. 29 However, the preamble to the proposed regulations explains that this "incidental benefit rule" relates solely to the qualified status of the plan and not to the tax treatment of any health benefits so provided. Previous IRS guidance on the incidental benefit rule holds that any profit-sharing plan funds used to pay for health benefits are treated as distributions and taxed under Secs. 402(a) and 72. That would continue to be the case under the proposed regulations.

The proposed regulations also address the possibility of a qualified plan trust purchasing a health insurance policy as an "investment" and then treating the insurer's payments to the trust for medical expenses as a "return on investment." The proposed regulations clarify that the payments from the insurance policy to the qualified plan trust "would be treated as having been made to the participant and then contributed by the participant to the plan." Of course, these contributions would have to be consistent with the plan's terms and applicable statutory limits (e.g., Sec. 415). Understandably, the proposed regulations did not address the issue of whether an investment of this type would meet ERISA's prudence and diversification standards.

The regulations will not be effective until calendar years after final regulations are issued. However, the preamble states that "no inference should be drawn that the payment of premiums from a qualified plan does not constitute a taxable distribution if made prior to the effective date of these regulations." Thus, the IRS may still find deficiencies during this period, and sponsors should review the technical basis for any position they are taking.

Health Savings Account Guidance

HSA Comparable Contribution Requirements
On April 17, 2008, the IRS published final regulations on two narrow—but important—issues relating to applying the "comparable contribution" requirements30 for employee HSAs. 31

First, the final regulations provide a way for employers to comply with the comparable contribution requirements for employees who are eligible individuals32 but who have not established an HSA by December 31, as well as for employees who may have established an HSA but have not notified the employer by that date. Specifically, the final regulations require employers to notify these employees in writing, by January 15 of the following calendar year, that if they establish an HSA and notify the employer by the last day of February they will receive a contribution to their HSA. Then, for those employees who set up an HSA and notify the employer by the February deadline, the employer must contribute comparable amounts (taking into account each month that the employee was a "comparable participating employee")33 plus reasonable interest. The employer can provide the notice electronically in accordance with Regs. Sec. 1.401(a)-21. The final regulations include sample language that employers can use in preparing their notices.

Second, the final regulations clarify how employers can accelerate contributions to certain employees in need without violating the comparable contribution requirements. Under the regulations, employers can make accelerated contributions to employees who, at that point in time, have incurred more qualifying medical expenses than the employer's cumulative HSA contributions. All comparable employees still must receive the same amount or the same percentage for the calendar year. The regulations acknowledge that employees who receive accelerated contributions and then terminate employment before the end of the year receive more contributions on a monthly basis than those who work the entire year. However, the regulations conclude that this will not result in a comparable contribution violation.

Accelerated contributions cannot be made in a discriminatory or inconsistent manner: Any accelerated contributions must be available throughout the calendar year on an equal and uniform basis to all eligible employees, and employers must establish reasonable uniform methods and requirements for accelerated contributions and the determination of medical expenses. 34

Employers may already rely on these final regulations. Unless further extended, they will apply to employer contributions made for calendar years beginning on or after January 1, 2009.

Special Full Contribution Rule
Effective for tax years beginning after December 31, 2006, the Health Opportunity Patient Empowerment Act of 2006 (HOPE Act) created a special "full contribution" rule permitting anyone who is an eligible individual as of the first day of the last month of his or her tax year (December 1 for calendar-year taxpayers) to make the maximum annual contribution to his or her HSA for that year even if he or she was not an eligible individual for the entire year. 35 To take advantage of this full contribution rule, the employee must maintain eligible individual status for all of the next tax year. Otherwise, the employee will have to include in income the amount of HSA contributions that he or she could not have made but for the full contribution rule and pay a 10% penalty on this amount.

Notice 2008-52 clarifies several important points about the full contribution rule and its application:

  • Someone who is an eligible individual for part of the tax year, but not on the first day of the last month of that tax year, cannot use the full contribution rule and must use the annual contribution limit based on the number of months he or she actually was an eligible individual.
  • The full contribution rule can apply even if the individual was covered by a non– high deductible health plan (HDHP) for part of the year. To qualify, the individual must be an eligible individual on the first day of the last month of his or her tax year; his or her status before that date is irrelevant to determining eligibility to use the full contribution rule.
  • The type of HDHP coverage (i.e., self only or family) the individual has on the first day of the last month of his or her tax year determines the applicable annual contribution limit for purposes of the full contribution rule. For example, if someone first became an eligible individual on December 1, 2007, and had family HDHP coverage as of that date, he or she is deemed to have had family coverage for all of 2007 under the full contribution rule even if the person had self-only coverage earlier in the year. This means the individual's HSA contribution for 2007 could have been $5,800—the annual limit for family coverage—instead of the $2,900 contribution limit for individuals with self-only coverage.
  • The full contribution rule also applies to catch-up contributions. In general, eligible individuals who are at least age 55 as of the last day of the calendar year and who are not enrolled in Medicare can make additional contributions to their HSAs. The catch-up contribution limit for 2008 is $900, increasing to $1,000 for 2009 and future years. Like the annual contribution limit, an individual's annual catch-up contribution limit generally is based on the number of months during the year that he or she was an eligible individual. However, an otherwise eligible individual who is at least age 55 and not enrolled in Medicare can use the full contribution rule to make a full catch-up contribution if he or she is an eligible individual as of the first day of the last month of his or her tax year.
  • Individuals who take advantage of the full contribution rule must maintain eligible individual status for a 13-month "testing period." According to Notice 2008-52, the testing period begins on the first day of the last month of the tax year and ends on the last day of the twelfth month following that month. For a calendar-year taxpayer who wants to use the full contribution rule in 2008, the testing period begins on December 1, 2008, and ends on December 31, 2009. 36
    • The income and excise tax consequences apply for any individual who takes advantage of the full contribution rule and fails to remain an eligible individual during the testing period unless the failure is due to the individual's death or disability. However, any earnings attributable to the excess contribution amount are neither included in the individual's gross income nor subject to the 10% excise tax.
    • There is no requirement to distribute excess contribution amounts from an HSA. In fact, if these amounts are distributed for any reason other than payment of qualified medical expenses, they will also be subject to tax penalties for nonqualified distributions. In other words, such amounts may be subject to double taxation.
Notice 2008-52 includes extensive examples to illustrate these and other principles related to applying the special full contribution rule.

Additional Guidance

The IRS issued Notice 2008-59 and proposed regulations to address a variety of open questions about HSAs. 37 The notice is a collection of 42 miscellaneous questions and answers, amplifying previous HSA guidance. 38
Contributions to HSAs
Contributions to spouse's HSA: Of note, Notice 2008-59, Q&A-26, confirms that where contributions are made to an employee's spouse's HSA, the contribution must be included in the employee's gross income and wages (unless the spouse is also the employer's employee). This is true even if the employer makes the contributions to the spouse's HSA under the employee's Sec. 125 salary reduction election.

Recouping HSA contributions: Notice 2008-59 also provides two limited exceptions to the general rule that the employer typically may not recoup its HSA contributions. The first exception (Q&A-23) applies if the employer contributes to the HSA of an employee who was never a proper eligible individual. 39 In this case, the employee's HSA was not really an HSA because the employee never was eligible to fund it. The employer can ask the financial institution to refund its contributions, but it must do so before the end of the tax year. Otherwise, the employer's contributions to the employee's account must be treated as gross income and wages to the employee on his or her Form W-2 for the year in which the employer made the contributions.

The second exception is available when the employer contributes more than the Sec. 223(b) maximum annual contribution limit to the employee's HSA due to an error. Again, the employer can ask the financial institution to return the excess amounts or simply include those amounts as gross income and wages on the employee's Form W-2 for the year in which the contributions were made. 40

Allocations of contributions to previous years: Notice 2008-59 clarifies that any employer contributions to an employee's HSA during the period January 1–April 15 can be allocated to the previous year. 41 The employer must notify the HSA trustee or custodian and the employee that contributions are being allocated to the previous year. However, the employer must report any contributions so allocated on the employee's Form W-2 for the year the contributions are actually made.

Coordinating HSA Eligibility with HRAs and Health FSAs
In previous guidance, the IRS identified a variety of ways employers could structure health reimbursement arrangements (HRAs) and health flexible spending accounts (FSAs) not to interfere with HSA eligibility status. These include limited-purpose HRAs and health FSAs, post-deductible HRAs and health FSAs, and retirement HRAs.

A limited-purpose HRA is one that only pays or reimburses specific Sec. 223(c)(2)(C) "permitted coverage" benefits (e.g., vision care, dental care, and preventive care), which can be provided below the HDHP deductible. Notice 2008-59, Q&A- 1, clarifies that a limited-purpose HRA can pay or reimburse the employee's premium costs for HDHP coverage. 42

In Rev. Rul. 2004-45,43 the IRS made it clear that a post-deductible HRA or health FSA can begin paying or reimbursing expenses as soon as the minimum required HDHP deductible is satisfied, even if the eligible individual's specific HDHP imposes a higher deductible. Notice 2008-59 extends the same reasoning to family HDHP coverage that imposes a single umbrella deductible for expenses incurred by all covered persons and lesser embedded deductibles for each covered individual. That is, there is no problem as long as the post-deductible HRA or health FSA does not begin payments or reimbursements until the statutory minimum deductible for family HDHP coverage (i.e., $2,200 for 2008) is satisfied.

Another question of considerable interest is whether employers can reimburse employees for medical expenses—or provide medical services directly to employees— before the minimum HDHP deductible is satisfied, without compromising the employees' ability to fund an HSA. Predictably, Notice 2008-59, Q&A-3, clarifies that employers may not pay or reimburse employees' medical expenses—except for preventive care services and permitted coverage—below the minimum HDHP deductible if those employees want to be eligible to fund HSAs.

Q&A-10, however, allows an otherwise eligible individual access to free or discounted health care services from a clinic on his or her employer's premises as long as "the clinic does not provide significant benefits in the nature of medical care (in addition to disregarded coverage or preventive care)." Other than a couple of specific examples in the notice, there is little guidance on exactly how far an employer can go before it is deemed to be providing "significant benefits in the nature of medical care."

Comparable Contributions
Prop. Regs. Sec. 54.4980G-6 provides long-awaited guidance on a special exception to the comparable contribution rule permitting (but not requiring) employers to contribute more to the HSAs of nonhighly compensated employees than to those of highly compensated employees.

This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader's particular situation. Copyright © 2008 Deloitte Development LLC. All rights reserved.


Deborah Walker is a tax partner at Deloitte Tax LLP in Washington, DC. Mark Neilio is a tax manager at Deloitte Tax LLP in Washington, DC. Michael Haberman is a tax manager at Deloitte Tax LLP in Parsippany, NJ. For more information about this article, contact Ms. Walker at, Mr. Neilio at, or Mr. Haberman at mhaberman@

1 American Jobs Creation Act of 2004, P.L. 108- 357, §885.

2 Notice 2006-4; Notice 2006-79; Notice 2006- 100; Notice 2007-37; Notice 2007-78; Notice 2007-86; Notice 2007-89; Notice 2007-100.

3 To the extent an issue is not addressed in Notice 2005-1, 2005-2 I.R.B. 274, or other applicable guidance, taxpayers must apply a reasonable, good-faith interpretation of the statute. Reliance on the final regulations will be considered a reasonable, good-faith interpretation of the statute. See Notice 2007-86.

4 Notice 2007-86, 2007-46 I.R.B. 990.

5 Subject to the "no in and out rule." This is a constructive receipt rule, outlined in the transition notices and preambles to the proposed regulation, that prohibits taxpayers from moving any payment into or out of the year in which the choice is being made.

6 This relief does not apply for certain insiders for whom transition expired at the end of 2006. See Notice 2007-86.

7 This does not apply for discounted options held by insiders.

8 Notice 2007-100, 2007-52 I.R.B. 1243.

9 Notice 2007-100, §II.B.

10 For further details, see Notice 2007-100, §IV.

11 A director, officer, or 10% owner of a corporation, or analogous persons for noncorporate service recipients.

12 See Notice 2007-100, §III.B.

13 Notice 2007-78, 2007-41 I.R.B. 780.

14 Regs. Secs. 1.409A-2(b)(2)(ii) and (iii).

15 IRS Letter Rulings 199949014 (9/9/99) and 200613012 (12/5/05).

16 Rev. Rul. 2008-13, 2008-10 I.R.B. 518.

17 Sec. 162(m)(4)(c); Regs. Sec. 1.162-27(e)(3)(i)(C).

18 Rev. Rul. 2008-32, 2008-27 I.R.B. 6.

19 Regs. Sec. 1.6039-1(a).

20 Regs. Sec. 1.6039-1(b).

21 Tax Relief and Health Care Act of 2006, P.L. 109-432, §403.

22 Notice 2008-8, 2008-3 I.R.B. 276.

23 REG-103146-08.

24 Rev. Rul. 91-26, 1991-1 C.B. 184.

25 Notice 2008-1, 2008-2 I.R.B. 251.

26 IRS examples illustrating these rules are set forth in the notice.

27 REG-148393-06.

28 Id.

29 See Regs. Sec. 1.401-1(b)(1)(ii); Rev. Rul. 61-164, 1961-2 C.B. 99.

30 In general, employers are not required to make contributions to employees' HSAs; however, if an employer makes any contributions to an employee's HSA, it must make comparable contributions to all comparable participating employees. The general rule is that contributions are comparable if they are either the "same amount or the same percentage of the deductible" of participants' high-deductible health plans. Regs. Sec. 54.4980G-4, Q&A-1.

31 T.D. 9393.

32 An eligible individual is someone who is covered by a high-deductible health plan (HDHP) and no other health insurance that is not an HDHP. For 2008, an HDHP generally is a health plan with a deductible of at least $1,100 for single coverage and $2,200 for family coverage and that limits out-of-pocket expenses to $5,600 and $11,200, respectively. (These amounts are subject to annual inflation adjustment.)

33 Generally, a comparable participating employee is an individual within the same category of employees who also has a similar HDHP (Regs. Sec. 54.4980G-3, Q&A-5(c)).

34 Regs. Sec. 54.4980G-4, Q&A-15.

35 Sections 303 and 305 of the Health Opportunity Patient Empowerment Act of 2006 included in the Tax Relief and Health Care Act of 2006, P.L. 109-432.

36 All that is required is for the individual to maintain eligible individual status for the entire testing period. The eligible individual does not have to maintain the same level (i.e., self only or family) of HDHP coverage throughout the testing period.

37 Notice 2008-59, 2008-29 I.R.B. 123; REG-120476-07.

38 See, e.g., Notice 2004-2, 2004-1 C.B. 269; Notice 2004-50, 2004-2 C.B. 196; Notice 2007-22, 2007-10 I.R.B. 670.

39 See note 32 above.

40 Notice 2008-59, Q&A-24.

41 Notice 2008-59, Q&A-21.

42 Note that limited-purpose health FSAs, like all health FSAs, may not pay or reimburse the cost of health insurance premiums under any circumstances. That is why Q&A-1 addresses only limited-purpose HRAs.

43 Rev. Rul. 2004-45, 2004-1 C.B. 971.

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