In regards to when a health savings account is overdrawn, we understand it should cease as a health savings account as of January 1st of the tax year the prohibited transaction occurred.

Can anyone help with how to go about this and how to ensure the tax forms are correct? We have a situation but are not sure how to address it especially since the employee still receives employer contributions.

Please assist! Thanks everyone!

As the custodian, paying the overdraft breaches your fidiciary responsibility as you loaned money to the individual which was the prohibited transaction, not the fact thay they potentially overdrew the account. You need to return all overdraft items and if you cannot, then they need to be collected from the customer outside of the HSA. You probably need to consult both tax and legal counsel at this point.

Is there a grace period to bring the account back into the black after it has been overdrawn? Or, does the extension of credit - no matter how short - strip away its status as a HSA?

Also, is there a majority standard on how to deal with overdrafts? Are most FIs taking the HSA account to zero and billing the HSA customer outside of the HSA?

There is no grace period. The minute the loan is made, the prohibited transaction has occurred.

That would be one way to handle it. Whatever is most efficient in your system for processing is what I would recommend.

When we have an item come in on an HSA account that will overdraw the account and that we cannot return (POS items) we post the POS item to a WIP account and collect the funds from the customer outside the HSA account. We also send the customer a letter quoting IRS requirements etc... We have one customer who is starting to abuse this process and are now considering closing his HSA account.

Do banks have an affirmative obligation to notify HSA customers about prohibited transactions related to over drafting? For instance, if a bank failed to give notice at account opening about its over draft policy re: prohibited transactions, what, if anything different, should the bank do when a prohibited transaction occurs?

"Do banks have an affirmative obligation to notify HSA customers about prohibited transactions"

No

"what, if anything different, should the bank do when a prohibited transaction occurs?"

Just don't do one. Take Midnight's advice. They overdraw the HSA - close the account if you do not wish mess around with them.

Are banks required to notify the IRS that a prohibited transaction (hence, a HSA is disqualified) has occurred?

What sort of prohibited transaction. One that the bank did? I would probably not recommend it in that case.

If a prohibited transaction occurs, that you are 100% certain of, you are required to report the account as distributed as of the the first day of the year in which the prohibited transaction occurred. There is a distribution code of 5 that would be placed on the 1099-SA.

The issue here is how are you certain a prohibited transaction occurred? Many people incorrectly believe that a non-qualified health expense is a prohibited transaction. It is not. The only instance that I can see where a custodian would know for certain that a prohibited transaction occurred would be when the custodian overdraws an HSA, resulting in an extension of credit to the HSA.

The prohibited transaction in that case would be the Bank's fault for loaning them the money to pay the overdraft. So, I would think that would set up the bank perfectly for a nice lawsuit.

Yes it would expose the bank to a lawsuit, but it would still be a prohibited transaction.