Employers are getting some welcome relief in the form of IRS
guidance that provides helpful details and clarity on how to
implement the upcoming $2,500 limit on salary reduction
contributions to health flexible spending accounts (FSAs) set by
the Patient Protection and Affordable Care Act (PPACA).
Notice 2012-40, which was issued by the IRS on
May 30, 2012, also provides a generous deadline for amending
cafeteria plans to reflect this new limit – before
year-end 2014 – and indicates that the Treasury
Department and IRS are considering modifying the
"use-it-or-lose-it" rule that has long troubled health
The PPACA affects health FSAs in several ways. For example, it
adds Internal Revenue Code Section 125(i), which imposes a $2,500
limit on salary reduction contributions to health FSAs effective
for "taxable years" beginning after December 31, 2012.
The $2,500 limit will be indexed for inflation in future years
(beginning December 31, 2013).
The PPACA requirements sometimes overlap with proposed cafeteria
plan regulations that the IRS issued in 2007. These proposed
regulations contain very explicit and detailed requirements as to
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 significant tax consequences. The issuance
of final regulations is on the Treasury agenda, and plan sponsors
must be aware of the impact they will have on their cafeteria plans
and health FSAs.
The $2,500 Limit – Plan Year
The Notice clarifies how the new $2,500 limit will operate. The
Notice specifies that the "taxable year" described under
the PPACA provision means the plan year for the relevant cafeteria
plan. This interpretation is easier for employers to administer
than alternatives would have been. The $2,500 limit on health FSA
salary reduction contributions will apply on a plan year basis
effective with plan years beginning after December 31, 2012.
The Notice addresses a few operational issues in dealing with
the $2,500 limit, all in ways that appear favorable to employers.
First, if a plan provides a grace period (i.e.,
participants in a calendar year health FSA have until March
15th 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 that subsequent year.
Second, the Notice provides guidance as to how employer
non-elective contributions (i.e., 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 willful neglect.
Request for Comments – Use-It-Or-Lose-It Rule
The IRS specifically requests comments in the Notice on the
use-it-or-lose-it rule under the proposed regulations. The IRS and
Treasury state that given the new limit, they are considering
modification of the use-it-or lose-it rule.
The Notice provided much needed guidance in dealing with the new
$2,500 limit for health FSAs. In light of the delayed plan
amendment requirement and outstanding final cafeteria plan
regulation, plan sponsors may want to consider waiting before
taking action with respect to their plan documents. Notwithstanding
this plan document consideration, plan sponsors must be ready to
comply from an operational perspective in 2013. Because many
cafeteria plans are operated on a plan year basis, this will
require action in late 2012 to ensure that plan participants are
notified of the changes and plan operations are updated
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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