Internal Revenue Service (IRS) Notice 2012-40 addresses a number of important issues regarding the implementation of the salary reduction limit for cafeteria plan health flexible spending accounts (health FSAs). Under the Patient Protection and Affordable Care Act, beginning in 2013, health FSAs must limit employee salary reductions to no more than $2,500 per year. This notice clarifies that the salary reduction limit will be applicable on a plan-year basis and will be effective for plan years beginning on or after January 1, 2013.

Although health FSAs must comply operationally with these limits in 2013, health FSAs have until December 31, 2014 to adopt an amendment reflecting this limit (with a retroactive effective date of the first day of the plan year beginning on or after January 1, 2013).

Some health FSAs provide a grace period (of up to two and a half months) following the end of the plan year in which participants may continue to incur expenses that can be reimbursed from amounts withheld during the prior plan year. This new guidance clarifies that if a health FSA provides a grace period, any unused salary reduction contributions for plan years beginning in 2012 or later that are carried over onto the grace period for that plan year will not count against the $2,500 limit for the subsequent plan year.

This notice also provides limited relief for health FSAs that mistakenly allow participants to make salary reduction contributions exceeding $2,500. Specifically, if the health FSA is amended to comply with this salary reduction limit by the end of 2014, the health FSA will not be disqualified if all of the following requirements are met:

  1. The terms of the plan apply uniformly to all participants.
  2. The error results from a reasonable mistake by the employer (or employer’s agent) and is not due to willful neglect.
  3. The salary reduction contributions in excess of $2,500 are paid to the employee and reported as wages for income tax withholding and employment tax purposes on the employee’s Form W-2 (or W-2c) for the employee’s taxable year in which, or with which, ends the health FSA plan year in which the correction is made.

This notice clarifies a number of issues regarding the implementation of the salary reduction limitation and provides a great deal of relief for plan sponsors trying to comply with the new law. (IRS Notice 2012-40)