Small companies need every advantage they can get to attract and retain the best and brightest employees. For decades, smaller companies who have chosen not to offer group health plans have competed by giving employees the option of choosing their own insurance on the open market. Then, after verifying the premium cost, the employer reimbursed the employee or paid the premium directly.

Unfortunately, under the Affordable Care Act, the Internal Revenue Service banned that procedure. The problem is that many small businesses are continuing the practice because they aren’t aware of the change.

The Price of Noncompliance

In September 2013, the IRS issued policy guidelines that defined “employer payment plans” as any situation where the employer is either reimbursing an employee for or directly paying the employee’s individual health insurance policy premiums and treating these payments as tax-free.

Plans of this kind, which are considered to be group health plans under the ACA, don’t comply with certain of the Act’s provisions—specifically, its requirement that certain preventive care coverage must be provided without cost sharing and its prohibition on annual limits for essential health benefits.

As of Jan. 1, 2014, failure to comply with the new IRS policy subjected the employer to a $100-per-day, per-employee excise tax. The financial impact on a small business could be immense: Over the course of last year, for a small business with only 10 employees whose premiums were being paid directly or reimbursed, the tax would have amounted to $365,000.

That’s before the continuing accrual of the daily tax in 2015, and before any penalties and interest the IRS might assess because the small business hasn’t reported the violation.

Short-Term Reprieve

Fortunately, in mid-February, the IRS offered a temporary reprieve. It created a grace period that continues through June 30, 2015, alleviating the per-employee penalty for all of 2014 and for the first half of 2015 for small businesses with fewer than 50 employees. As of July 1, however, companies that have not come into alignment again become subject to the penalty.

The amnesty period should be considered an opportunity to make sure the company’s health care offerings comply with ACA requirements. A small business has two options for correcting the offending arrangements:

• They can purchase a group health plan for their employees.
• They can continue to allow employees to seek individual coverage and, if the business still wants to foot the bill for employee premiums, it must increase the employee’s salary. This approach subjects the pay increase to income and payroll taxes. In addition, the company cannot condition the compensation increase on the employee using the extra money to pay for health coverage. The employee must be free to use the additional salary as he or she wishes. If the employee chooses to use the increase to pay for premiums, the employer cannot endorse a particular policy or insurance provider.

Small businesses may chafe at both of these options. Either is likely to be more expensive than the traditional practice has been, and employers may not see either alternative as offering a significant recruiting or retention benefit. They are, however, far less costly than accruing daily penalties for noncompliance.

It’s worth noting that some small benefits companies have developed products that they are advertising as ways for employers to continue reimbursing employees for insurance premiums without running afoul of ACA requirements. However, these products haven’t yet been tested by the IRS, so small businesses should not pursue them without engaging legal counsel in the evaluation and decision-making process.