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New IRS Guidance on Health Care Flexible Spending Accounts: What Does It Mean for Employers?

July 2012

The United States Supreme Court’s ruling that the so-called “individual mandate” under the Patient Protection and Affordable Care Act of 2010 (the “Act”) passes constitutional muster promises to change the health care landscape for years to come. Unless repealed, many of the Act's changes will take effect as early as 2014.

However, one such change, which has not received as much attention as many of the other changes, will take effect in 2013. This change limits the amount that an employee can defer annually under a health care flexible spending account (“Health FSA”) to $2,500.

By way of background, a Health FSA permits an employee to pay for out-of-pocket medical expenses – e.g., prescription drug and doctor’s visits co-payments – on a pre-tax (for federal income and FICA tax purposes) basis. Prior to the Act becoming law, the annual Health FSA limit was set by the employer and, as a matter of business practice, typically ranged between $2,500 and $5,000. An employer that was concerned with turnover and losing “unfunded” account balances (an employer must make the entire year’s deferral amount available from day 1 of the year, even if the employee has not contributed an amount sufficient to cover expenses) tended to set a lower limit. In contrast, an employer that was less concerned with turnover and losing unfunded account balances, tended to set a higher limit. As a result of the Act, an employer has considerably less flexibility in setting a Health FSA annual limit.

Effective Date
The $2,500 cap takes effect for plan years beginning after December 31, 2012. Thus, if the plan year for a Health FSA is the calendar year, the cap takes effect on January 1, 2013. However, if the plan year for a Health FSA is other than the calendar year, the cap takes effect on the first day of such plan year. For example, if the plan year is May 1 to April 30, the cap takes effect on May 1, 2013. Cost-of-living increases to the cap will be made annually by the IRS, and will take effect on the first day of an applicable plan year.

Scope of $2,500 Limit
Recent IRS guidance (IRS Notice 2012-40) provides an employer that sponsors a Health FSA with some useful information on the scope of the $2,500 limit and on how to administer the new limit.

Employee Deferrals Only
The $2,500 limit applies only to employee contributions and does not apply to employer non-elective contributions, sometimes called “flex credits.” Accordingly, an employer faced with a reduction in the limit may wish to consider making up some of the reduction with flex credits. Doing so could provide such an employer with a competitive advantage in retaining or recruiting employees.

Employee-by-Employee Basis
The $2,500 annual contribution limit applies on an employee-by-employee basis. Accordingly, if two spouses work for the same employer, each spouse can elect up to the limit set by the employer (e.g., $2,500 each for a “family” total of $5,000).

Controlled Group Basis
The $2,500 limit applies on a “controlled group” basis. Accordingly, if an employee performs services for two or more corporations (partnerships, LLCs, etc.) related by ownership (e.g., parent – subsidiary), each of which has its own Health FSA, the employee’s total contributions under all Health FSAs within is limited to $2,500 (or such lower amount resulting from the aggregation of the individual limits).

Grace Period Not Taken into Account
Many Health FSAs contain a grace period under which expenses incurred up to two and one half months after the end of the plan year may be reimbursed from contributions made during the plan year. IRS Notice 2010-40 clarifies that, if a Health FSA contains a grace period, then any unused employee contributions carried over to such grace period do not count against the $2,500 limit. For example, in the case of a calendar year plan, employee contributions carried over to the grace period starting January 1, 2013 and ending March 15, 2013 do not count against the 2013 annual limit of $2,500.

Other Employer-Provided Coverage Not Covered
The $2,500 annual limit added by the Act applies only to a Health FSA, not to other employer-provided coverage, such as contributions to an FSA for dependent care assistance or adoption assistance, employee contributions to a health savings account or health reimbursement account, or employee contributions to a cafeteria plan to pay for health care premiums under an employer-sponsored plan on a pre-tax basis. Other tax rules may impose annual contribution limits – e.g., in the case of a dependent care FSA or a health savings account.

Employer Action Items
An employer that sponsors a Health FSA would be well-served to consider doing the following during the second half of 2012:

Evaluate Limit and Use of Flex Credits
An employer whose Health FSA limit currently exceeds $2,500 should consider evaluating whether to reduce its limit below $2,500 and/or introduce or increase flex credits to make up for the reduced employee contributions. In this regard, it is worth noting that, in Notice 2012-40, the IRS specifically requested comments on whether the so-called “use-or-lose” rule (under this rule an employee who does not use the entirety of his or her contributions by the end of the plan year or, if applicable, the end of the grace period, forfeits the unused dollars) should be changed. One obvious option would seem to be to eliminate or at least scale back the use-or-lose rule – i.e., by providing unlimited or partial (for a certain number of years or a certain dollar amount) “carryover” to subsequent plan years. The comment period closes on August 17, 2012.

Communicate Changes to Employees
Communications of the changes to employees, well in advance of the beginning of the next plan year, are essential. Open enrollment time would appear to be the most obvious choice of a time frame.

Amend the Health FSA
Technically, Notice 2012-40 permits amendments to be made to an employer’s Health FSA document as late as December 31, 2014 to incorporate the $2,500 limit. Nonetheless, an employer should consider making the required amendment by December 31, 2012. Doing so will highlight the change, which could have the effect of making it less likely that the employer would allow an employee to defer above the limit. To this end, the IRS has clarified that, while mistakenly allowing a greater contribution can be corrected (by paying the funds back to the employee and reporting the amount on the employee’s W-2), the mistake must be reasonable and not due to willful neglect.

Contact Us
Please contact your Wolff & Samson attorney or any member of the firm’s Employee Benefits and Executive Compensation Group for assistance in complying with this new rule.