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IRS Guidance on Health FSAs and $2,500 Contribution Limit

Employee Benefits Law Alert John L. Barlament

On May 30, the Internal Revenue Service ("IRS") issued new, helpful guidance relating to contribution limits for health flexible spending arrangements ("Health FSAs"). The health care reform law, the Patient Protection and Affordable Care Act (now called the ACA by federal regulators), stated that employee contributions to Health FSAs had to be capped at $2,500 (the "$2,500 Limit Rule"). The new IRS notice clarifies that the $2,500 Limit Rule applies for plan years beginning on or after January 1, 2013. In addition, the notice allows employers to wait until the end of 2014 before amending their Health FSA plan document to reflect this change (although employers may want to act before then). The notice also makes a few other helpful changes, as described more below.

Background on Change. The ACA provides that an employee may not elect "for any taxable year" to make Health FSA salary reduction contributions in excess of $2,500. The ACA was fairly clear that this limit only relates to employee salary reduction contributions and not to employer contributions (such as a matching contribution or an employee's election to use flex dollars provided by an employer). Unfortunately, the ACA was unclear about the meaning of "taxable year" and whether that year refers to an employee's tax year, an employer's tax year or the Health FSA's plan year. The ACA was also unclear on how this rule applies to amounts carried over to the following year - i.e., a "grace period." The new IRS notice resolves these questions.

Taxable Year. The "taxable year" that applies is the cafeteria plan's plan year. (A Health FSA with employee pre-tax contributions will always be part of a cafeteria plan.) The $2,500 Limit Rule applies to the first plan year of a cafeteria plan which begins after December 31, 2012. For example, a calendar year plan will first be subject to the $2,500 Limit Rule on January 1, 2013. However, a cafeteria plan with a June 1 - May 31 plan year will first be subject to the $2,500 Limit Rule on June 1, 2013. Both of these are true regardless of the employer's taxable year or a participant's personal taxable year.

An employer will need to be aware of these rules when preparing enrollment materials. For example, many calendar year Health FSA plans will hold an open enrollment in October or November 2012. The open enrollment materials should inform eligible individuals of the $2,500 Limit Rule. The materials should be designed to ensure that the $2,500 Limit Rule cannot be violated (i.e., they should prevent an employee from electing more than $2,500 in employee salary reduction contributions).

Amendment Required. An employer will need to amend its Health FSA and cafeteria plan document to ensure that the $2,500 Limit Rule is included. The IRS notice allows an employer until December 31, 2014 to make this amendment. Despite this lengthy time period, an employer may want to amend the plan document and related materials (such as a summary plan description, an employee handbook or perhaps a summary of benefits and coverage ("SBC")) before that date. Waiting until the end of 2014 could result in some confusion, as the plan documents used in 2013 and most of 2014 would usually contain inaccurate information (e.g., they may reflect an inaccurate, higher maximum contribution, such as $5,000). Although not completely clear, in some situations the SBC rules may require an earlier change to the SBC.

Grace Period. An employer can include a grace period for its Health FSA. If the employer does so, unused salary reduction amounts in one plan year "carry forward" and can be used for up to two and one-half months of the next plan year. The IRS notice provides that these carried over amounts do not count against the $2,500 limit for the next plan year.

Example of Grace Period. Client Co. maintains a calendar year Health FSA. The Health FSA has a two and one-half month grace period. Paul the Participant elected to contribute $5,000 to the Health FSA in 2012. During 2012 Paul only uses $2,000 of the $5,000 maximum. Paul can use the remaining $3,000 that is carried over for expenses incurred through March 15, 2013. In addition, Paul elects to contribute $2,500 for 2013. In essence, Paul has $5,500 available to him for some portion of 2013 (the $3,000 that is carried over from 2012 and the new 2013 contribution of $2,500). This $5,500 available amount does not violate the $2,500 Limit Rule because the $3,000 that is carried over is ignored.

Indexed for Inflation. The $2,500 limit is indexed for cost-of-living adjustments for plan years beginning after December 31, 2013. Employers should consider incorporating this adjustment by reference into their cafeteria plan documents. This will help ensure that the employer will not need to amend the plan each year to increase the limit, as the adjustment will occur automatically.

Short Plan Years. The new IRS notice states that the $2,500 limit is prorated based on the number of months in a short plan year.

Limit Not Applicable to Other Benefits. The $2,500 Limit Rule does not apply to other benefits that can be offered under a cafeteria plan, such as dependent care assistance or an employee's election of pre-tax amounts to pay for health plan premiums.

Limit Applies on Employee-by-Employee, Employer-by-Employer Basis. The $2,500 limit applies with respect to each employee. So, if an employer employs two individuals who are married to each other, each of the employees may elect $2,500 under the Health FSA (and therefore receive a total family benefit of $5,000).

Similarly, employers that are part of a controlled group are generally all considered to be a single employer. If an employee participates in multiple Health FSAs offered by employers in the same controlled group, the amounts elected under each Health FSA must be aggregated in determining whether the employee has reached the $2,500 limit. If the employers are not part of the same controlled group there is no aggregation.

Correction Procedure. The IRS notice provides a correction procedure for some situations where the $2,500 Limit Rule is inadvertently violated.

Possible Changes to "Use-or-Lose" Rule?  Intriguingly, the IRS notice requests comments on whether the "use-or-lose" for Health FSAs should be modified. Under that rule, unused Health FSA amounts are forfeited at the end of the plan year (or end of the grace period, if any). The IRS requests comments on whether the rule should be modified and, presumably, weakened. Separately, the U.S. House of Representatives is currently considering a bill which would allow up to $500 of unused funds to be returned to a Health FSA account holder. It is unclear whether either initiative will move forward.

Effective Date of Notice. The IRS notice is effective immediately. However, its practical impact becomes effective in 2013.

Copy of Notice:  A copy of the IRS notice is available here.

For more information contact the author of this alert, John Barlament, at (414) 277-5727 / [email protected]. You may also contact any of the following Quarles & Brady employee benefits attorneys: Marla Anderson at (414) 277-5453 / [email protected], Amy Ciepluch at (414) 277-5585 / [email protected], Sarah Fowles at (414) 277-5287 / [email protected], Angie Hubbell at (312) 715-5097 / [email protected], Paul Jacobson at (414) 277-5631 / [email protected], David Olson at (414) 277-5671 / [email protected] or Robert Rothacker at (414) 277-5643 / [email protected]