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IRS Guidance for Health FSAs

Posted 12:00 PM by

Starting in 2013, there are new rules about the amount that can be contributed to health flexible spending arrangements (FSAs). Notice 2012-40 provides information about the new rules and flexibility for employers applying the new rules, and requests comments about other possible administrative changes to the rules on FSA contributions. In the Notice, the Internal Revenue Service (IRS) has provided clarity on how to implement the upcoming $2,500 limit on salary reduction contributions to health FSAs set by the Patient Protection and Affordable Care Act (PPACA).

The Notice, which was issued by the IRS on May 30, 2012, also provides the deadline (before the end of the 2014 plan year) for amending cafeteria plans to reflect this new limit. The Treasury Department and the IRS are considering modifying the “use-it-or-lose-it” rule that has long troubled health FSA participants.

Background

The PPACA affects health FSAs by adding Internal Revenue Code Section 125(i), which stipulates a $2,500 limit on salary reduction contributions to health FSAs effective for taxable years beginning after Dec. 31, 2012. The $2,500 limit will be indexed for inflation in future years. Through 2012, employees could establish their own limits as long as the limits were disclosed in the plan document. 

The PPACA requirements overlap with proposed cafeteria plan regulations that the IRS issued in 2007. These proposed regulations contain requirements regarding what must be included in a written cafeteria plan document. One requirement is to specify the maximum amount of salary reduction contributions that may be made to a health FSA. The proposed regulations generally require plan amendments to be adopted prior to the date when they become effective. The proposed regulations also contain the “use-it-or-lose-it” rule, which generally prohibits contributions under a health FSA from being used in a subsequent plan year or period of coverage. Failure to satisfy these rules would trigger disqualification of the entire arrangement resulting in adverse tax consequences. Plan sponsors must be aware of the impact the new guidance will have on their cafeteria plans and health FSAs.

Interpretation

The Notice clarifies how the new $2,500 limit will operate. It specifies that the “taxable year” described under the PPACA provision means the plan year and not the taxable year of the plan sponsor. The $2,500 limit on health FSA salary reduction contributions will apply on a plan year basis effective for plan years beginning after Dec. 31, 2012.

The Notice also addresses operational issues in dealing with the $2,500 limit. First, if a plan provides a grace period (i.e., participants in a calendar year health FSA have until March 15 of the following plan year to incur expenses and get reimbursements), unused salary reduction contributions carried over into the next year would not count against the $2,500 limit for the subsequent year. Not all health FSA plan documents contain this provision and a plan sponsor cannot apply this operational rule unless it is in the plan document.

Second, the Notice provides guidance as to how employer non-elective contributions, sometimes referred to as flex credits, are to be accounted for in dealing with the $2,500 limit. If such flex credits must be used for a qualified benefit such as a health FSA, the participant may still elect to make a salary reduction contribution of $2,500. However, if the flex credit may be used for the qualified benefit or cashed out, those flex credits will be treated as a salary reduction contribution and, as a result, will impact the amount of salary reduction contribution that a participant may make.

Third, the Notice provides relief and the opportunity for correction in the event that salary reduction contributions exceed the $2,500 limit, and if it was the result of a reasonable mistake and not due to the employer’s neglect.

Request for Comments -- Use-It-or-Lose-It Rule

The IRS specifically requested comments in the Notice on the use-it-or-lose-it rule under the proposed regulations. The IRS and the Treasury Department are considering modification of the use-it-or-lose-it rule.  The comment period ended Aug. 17, 2012 and may result in the liberalization of the use-it-or-lose-it rule.

Conclusion

Notice 2012-40 provided some needed guidance in dealing with the new $2,500 limit for health FSAs. Due to the delayed plan amendment requirement and outstanding final cafeteria plan regulation, plan sponsors have generally been waiting before taking action with respect to their plan documents. However, plan sponsors must be ready to comply from an operational perspective in 2013. Because many cafeteria plans are operated on a calendar year basis, this will require action in late 2012 to ensure that plan participants are notified of the changes and plan operations are updated accordingly.

The contents of this message are for informational purposes only. If you have any questions regarding Notice 2012-40 and its impact on your health FSA, please contact any of the following members of our Employee Benefit Plan Services Group.

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