Can I offer an HRA only to my key employees?

All employees in the same class should be treated equally. An HRA does not have to benefit all employees so long as benefits offered to one or more classes of employees do not discriminate in favor of highly compensated individuals.

HRA reimbursements are tax-free to employees. However, each class within an HRA must comply with certain rules for “highly compensated individuals” (HCIs) within the class in order to enjoy all tax savings. HCIs include the highest paid five company officers, shareholders with more than 10 percent of the employer’s stock, and/or the highest paid 25 percent of employees. However, they exclude self- employed individuals (e.g. sole proprietors), partners, and S-Corp shareholders who hold more than two percent of their company’s stock. The Section 105 rules each HRA class must meet are as follows:

1. Eligibility. An HRA class must not be set up in a way that not disproportionately benefits, or “discriminates” in favor of, HCIs.[1]
2. Discrimination. Benefits offered within an HRA class must not discriminate in favor of “highly-compensated individuals” (HCIs) within that class.

The IRS considers “all facts and circumstances” in determining whether an HRA or class within an HRA complies with these rules. Employers are responsible to make sure classes meet these requirements. To the extent employers adhere to the following three guidelines, they are more likely to meet these tests and ensure tax-free reimbursement for all employees in the HRA.

1. Create classes based on objective business criteria. These may include job categories, geographic location, part-time or full-time status, date of hire, etc.
   
2. Ensure classes do not consist primarily of HCIs. An HRA class with only a nominal number of employees who are not HCIs may be considered discriminatory.
3. Explicitly specify the basis on which discrimination testing will occur in the plan document.

The consequences for violating Section 105 eligibility and discrimination rules are not significant. If, upon audit, an HRA class is found to violate these rules, the HCIs who received HRA reimbursements must pay income taxes on the “excess” portion of the reimbursements they actually received. HCIs do not pay income taxes on the allowances they do not use or on their entire reimbursement. Moreover, their HRA reimbursements are still exempt from FICA and FUTA taxes and are fully deductible by the employer.

Violating the eligibility and discrimination tests described above does not mean other employees are entitled to the higher level of benefits received by HCIs or other classes. Similarly, a violation does not cancel or otherwise invalidate the HRA or jeopardize the company's ability to deduct all HRA reimbursements.