On May 30, 2012, the IRS issued Notice 2012-40 (the “Notice”) to provide guidance on the effective date of the $2,500 statutory limit (as indexed for inflation) on salary reduction contributions to health flexible spending arrangements (Health FSAs) and the deadline for amending plans to comply with such limit. The Notice also provides relief for certain contributions that mistakenly exceed the $2,500 limit and that are corrected in a timely manner. Finally, the Notice requests comments on whether to modify the “Use It or Lose It” rule that is currently set forth in the Proposed Regulations under Internal Revenue Code (“Code”) Section 125 that apply to Health FSAs (the “125 Proposed Regulations”).

Background

In 2007, the Treasury Department and the Internal Revenue Service published the 125 Proposed Regulations. The 125 Proposed Regulations require a written cafeteria plan providing a Health FSA to specify the maximum salary reduction contribution as a maximum dollar amount, a maximum percentage of compensation, or other method of determining the maximum salary reduction contribution. If a cafeteria plan fails to operate in compliance with Code Section 125 or fails to satisfy any of the written plan requirements for Health FSAs, the plan is not a Code Section 125 cafeteria plan and an employee’s election of nontaxable benefits results in gross income to the employee.

A cafeteria plan may include a grace period of up to two months and 15 days immediately following the end of the plan year. If the plan provides for a grace period, an employee may use amounts remaining from the previous plan year to pay for expenses incurred for certain qualified benefits during the grace period.

Code Section 125(i) was added to the Code by the Patient Protection and Affordable Care Act (as amended by the Health Care and Education Reconciliation Act of 2010 (the “Act”)). Code Section 125(i) provides that a Health FSA is not treated as a qualified benefit unless the cafeteria plan “provides that an employee may not elect for any taxable year to have salary reduction contribution elections in excess of $2,500 made to such arrangement.” Code Section 125(i) is effective for “taxable years” beginning after December 31, 2012. Prior to the effective date of Code Section 125(i), there is no statutory limit on the amount of salary reduction contributions that employees could elect to contribute to Health FSAs.

Effective Date

Code Section 125(i) provides that a Health FSA may not allow an employee to elect for any taxable year to have salary reduction contributions in excess of $2,500. The Notice clarifies that because employees make salary reduction contribution elections for Health FSAs only on a plan year basis, the term “taxable year” in Code Section 125(i) refers to the plan year of the cafeteria plan. Accordingly, the $2,500 limit on Health FSA salary reduction contributions applies on a plan year basis and is effective for plan years beginning after December 31, 2012. For example, for a plan with a July 1 - June 30 plan year, the new $2,500 limit will apply to the plan year that begins July 1, 2013.

The Notice clarifies that a plan year may be changed only for a valid business purpose. If a principal purpose of changing from a calendar year to a fiscal year is to delay the application of the $2,500 limit, the change is not for a valid business purpose. If a cafeteria plan has a short plan year (i.e., fewer than 12 months) that begins after 2012, the $2,500 limit must be prorated based on the number of months in such short plan year.

Limit Applies to Employee Contributions Only

The Notice states that the $2,500 statutory limit applies only to salary reduction contributions under a Health FSA. Such limit does not apply to employer non-elective contributions (also known as flex credits). Generally, an employer may make flex credits available to an employee who is eligible to participate in the cafeteria plan, to be used (at the employee’s election) only for one or more qualified benefits. For example, if an employer contributes a $500 flex credit to each employee’s Health FSA for the 2013 plan year, each employee may still elect to make salary reduction contributions of $2,500 (as indexed for inflation) to a Health FSA for that plan year. However, if an employer provides flex credits that employees may elect to receive as cash or as a taxable benefit, those flex credits are treated as salary reduction contributions for purposes of Code Section 125(i).

The Notice clarifies that the $2,500 statutory limit applies on an employee-by-employee basis. Thus, $2,500 (as indexed for inflation) is the maximum salary reduction contribution each employee may make for a plan year, regardless of the number of other individuals (i.e., a spouse, dependents, or adult children) whose medical expenses are reimbursable under the employee’s Health FSA. Consequently, if each of two spouses is eligible to elect salary reduction contributions to an FSA, each spouse may elect to make salary reduction contributions of up to $2,500 (as indexed for inflation) to his or her Health FSA, even if both participate in the same Health FSA sponsored by the same employer.

The Notice also clarifies that Code Section 125(i) does not limit the amount permitted for reimbursement under other employer-provided coverage, including the following: 

  • Employee salary reduction contributions to an FSA for dependent care assistance or adoption care assistance.
  • Salary reduction contributions to a cafeteria plan that are used to pay an employee’s share of health coverage premiums (sometimes referred to as “premium conversion” salary reduction contributions)
  • Health savings account or amounts made available by an employer under a health reimbursement arrangement.

Grace Period

The Notice provides that if a plan provides for a grace period (which can be no longer than two months and 15 days) for a plan year, unused salary reduction contributions to the Health FSA for the plan year that are carried over into the grace period do not count against the $2,500 limit applicable for the subsequent plan year.

Controlled Groups

According to the Notice, all employers that are treated as a single employer under the rules relating to controlled groups and affiliated service groups (Code Sections 414(b), (c) or (m)), are treated as a single employer for purposes of the $2,500 limit. If an employee participates in multiple cafeteria plans offering Health FSAs maintained by members of a controlled group or affiliated service group, the employee’s total Health FSA salary reduction contributions under all of the cafeteria plans are limited to $2,500 (as indexed for inflation).

Excess Contributions

If a cafeteria plan timely complies with the written plan requirement limiting Health FSA salary reduction contributions, but one or more employees are erroneously allowed to elect a salary reduction of more than $2,500 (as indexed for inflation) for a plan year, the cafeteria plan will continue to be a Code Section 125 cafeteria plan for that plan year if (i) the terms of the plan apply uniformly to all participants, (ii) the error results from a reasonable mistake by the employer and is not due to willful neglect by the employer, and (iii) salary reduction contributions in excess of $2,500 (as indexed for inflation) are paid to the employee and reported as wages for income tax withholding and employment tax purposes on the employee’s Form W-2, Wage and Tax Statement (or Form W-2c, Corrected Wage and Tax Statement) for the employee’s taxable year in which, or with which, ends the cafeteria plan year in which the correction is made.

The Notice clarifies that such relief for erroneous excess contributions is not available for an employer if a federal tax return of the employer is under examination with respect to benefits provided under a cafeteria plan with respect to any cafeteria plan year during which the failure to comply with Code Section 125(i) occurred. For this purpose, an employer is treated as under examination if the employer receives written notification (for example, by plan examination, information document request, or notification of proposed adjustments to a federal tax return) from the examining agent specifically citing Code Section 125(i) as an issue under consideration.

Retroactive Amendment Permitted

According to the Notice, plan sponsors can amend their Health FSA to include the $2,500 limit as late as December 31, 2014, as long as the amendment is retroactively effective for plan years beginning after December 31, 2012, and the Health FSA is operated to reflect the limit beginning on the effective date. A written cafeteria plan may specify the maximum salary reduction contribution as a maximum dollar amount or by another method of determining the maximum amount of salary reduction contributions to a Health FSA, but in no case may the plan permit a participant to make salary reduction contributions, for a plan year beginning after December 31, 2012, in an amount that exceeds the $2,500 limit.

Generally, the 125 Proposed Regulations require plan amendments to be adopted before they become effective. The retroactive amendment relief provided in the Notice may indicate that the IRS is considering relaxing the “prospective-only” amendment rule in the 125 Proposed Regulations.

Examples

The rules of the Notice are illustrated by the following examples. For all examples, it is assumed that the cafeteria plan otherwise satisfies all of the requirements of Code Section 125 and the 125 Proposed Regulations and that the employer is not a member of a controlled group or affiliated service group.

Example 1: Employer A offers a calendar year cafeteria plan, including a Health FSA. Employer A amends its written cafeteria plan by December 31, 2014 to provide that, effective for a plan year beginning on January 1, 2013, employee salary reduction contributions to the Health FSA are limited to $2,500 (as indexed for inflation). 

  • Employer A’s written cafeteria plan satisfies the requirements of Code Section 125(i).

Example 2: Employer B offers a calendar year cafeteria plan including a Health FSA with a grace period of two months and 15 days that complies with IRS Notice 2005-42 and the 125 Proposed Regulations. Effective for the 2012 plan year, the written plan provides that employee salary reduction contributions for the Health FSA are limited to $4,000. Effective for the 2013 plan year, the written plan provides that employee salary reduction contributions to the Health FSA are limited to $2,500 (as indexed for inflation). Some employees have unused amounts from their 2012 Health FSA salary reduction contributions that remain available during the grace period in the first two months and 15 days of 2013.

  • The availability during the grace period of amounts attributable to 2012 Health FSA salary reduction contributions does not cause Employer X’s cafeteria plan to fail to satisfy the $2,500 limit.

Possible Modification of Use It or Lose It Rule for Health FSAs

In addition to providing guidance on the $2,500 statutory limit added under the Act, the Notice also provides that the Treasury Department and IRS are considering whether, for Health FSAs, the position contained in the 125 Proposed Regulations that is often referred to as the “Use It or Lose It” rule should be modified. Such rule generally prohibits any contribution or benefit under a Health FSA not used in one year from being used in a subsequent plan year or period of coverage. Consequently, under the Use It or Lose It rule, unused amounts in the Health FSA are “forfeited” at the end of the plan year.

Given the new $2,500 limit, the Treasury Department and IRS are considering whether the Use It or Lose It rule for Health FSAs should be modified to provide a different form of administrative relief (instead of, or in addition to, the current 2 ½ month grace period rule). Comments are requested with respect to whether the 125 Proposed Regulations should be modified to provide additional flexibility for operation of the Use It or Lose It rule for Health FSAs. Comments are also requested on how any such modifications would interact with the $2,500 limit.

Consistent with these thoughts, on May 31, 2012, the House Ways and Means Committee approved legislation (consolidated bill HR 436) to mitigate the Use It or Lose It rule for Health FSAs. The bill would allow unspent funds in a Health FSA to be distributed as taxable income up to $500 by the end of the seventh month after the close of the plan year.

Conclusion

The Notice is welcome guidance for employers trying to comply with the new statutory limit for Health FSAs. Information systems and administrative processes will need to be modified and annual enrollment communications prepared before 2013 to reflect the $2,500 limit. King & Spalding is happy to assist you with any questions you may have regarding compliance with the Notice.