On May 30, 2012, the Internal Revenue Service released Notice 2012-40 to provide guidance on the $2,500 limit on salary reduction contributions to health flexible spending arrangements under Section 125(i) of the Internal Revenue Code of 1986, as amended (the “Code”). Section 125(i) is effective for taxable years beginning after December 31, 2012. 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 current “use-it-or-lose-it” rule under which unused amounts in a health flexible spending account (“FSA”) are forfeited at the end of the plan year.
Contributions Subject to $2,500 Limit
The $2,500 limit on contributions to health FSAs was enacted as part of the Patient Protection and Affordable Care Act, and amended by the Health Care and Education Reconciliation Act of 2010, and applies only to salary reduction contributions under a health FSA. This means that payments or reimbursements for the employee share of deductibles, co-payments, co-insurance and Code Section 213(d) medical expenses not reimbursed by insurance paid through the FSA count against the $2,500 limit. Further, health FSAs apply to health, dental, and vision plans in the aggregate. However, the limit does not apply to certain employer non-elective contributions, sometimes referred to as flex credits. If flex credits must be used for a qualified benefit, the employee may still elect to make salary reduction contributions of $2,500 to a health FSA for that plan year. However, if the flex credits can be received as cash or as a taxable benefit, those flex credits are treated as salary reduction contributions subject to the $2,500 limit.
Further, the $2,500 limit does not apply to any types of contributions for reimbursement under other employer-provided coverage, such as employee salary reduction contributions to an FSA for dependent care assistance or adoption care assistance. The limit also does not apply to salary reduction contributions to a cafeteria plan that are used to pay an employee’s share of health coverage premiums nor does it apply to contributions to a health savings account or to amounts made available by an employer under a health reimbursement arrangement.
$2,500 Limit Applies on Employee-by-Employee Basis
The Notice provides that the $2,500 limit applies on an employee-by-employee basis per controlled group employer. Therefore, if only one spouse is employed, $2,500 is the limit regardless of the number of other individuals whose medical expenses are reimbursable under the employee’s health FSA. If both spouses are employed, each may elect salary reduction contributions up to $2,500, even if both spouses participate in the same health FSA sponsored by the same employer. In effect, the $2,500 limit applies regardless of whether the employee is single or has a spouse and/or dependents and regardless of whether the employee elects single, single plus one, or family coverage in a health plan.
Participation in Multiple Cafeteria Plans
If an employee participates in multiple cafeteria plans offering a health FSA that are maintained by members of a controlled group, the employee’s total health FSA salary reduction contributions under all of the cafeteria plans are limited to $2,500. However, an employee employed by two or more employers that are not members of the same controlled group may elect up to $2,500 under each employer’s health FSA.
Application of $2,500 Limit to Grace Period
For plans providing a grace period, unused salary reduction contributions for plan years beginning in 2012 or later that are carried over and used in a grace period relating to that plan year will not count against the $2,500 limit for the subsequent plan year.
$2,500 Limit Applies on Plan Year Basis
The Notice provides that the term “taxable year” in Section 125(i) refers to the plan year of the cafeteria plan, as this is the period for which salary reduction elections are made. Also, the $2,500 limit does not apply to plan years that begin before 2013. Therefore, the limit applies on a plan year basis and is effective for cafeteria plan years beginning after December 31, 2012. The $2,500 limit will also be indexed for cost-of-living adjustments for plan years beginning after December 31, 2013.
Consequence for Noncompliance
Cafeteria plans must be amended to comply with the $2,500 limit by December 31, 2014. Unless the limited relief for reasonable mistake described below is available, plans that are not amended by this date and do not comply with other guidance in the Notice will lose their tax qualified status, resulting in an employee’s election of nontaxable benefits being taxable as gross income to the employee.
Relief for Reasonable Mistake
In the Notice, the Internal Revenue Service also included relief for employees who are erroneously allowed to elect a salary reduction of more than $2,500 for a plan year. Although not available if the employer’s tax return is under examination for failure to comply to comply with the $2,500 limit, the cafeteria plan will continue to be a Section 125 cafeteria plan for that plan year if:
- The terms of the plan apply uniformly to all participants;
- The error results from a reasonable mistake by the employer and is not due to willful neglect by the employer; and
- 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.
Comments Requested on “Use-it-or-lose-it” Rule
The Treasury Department and the Internal Revenue Service are also 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, a grace period. As a result, comments are requested on whether certain proposed regulations should be modified to provide additional flexibility and, if so, how any such flexibility might be formulated and constrained. Comments must be submitted by August 17, 2012 in the manner outlined in the Notice. The complete text of Notice is available here.
Employers who sponsor cafeteria plans and health FSAs and amend their plans to comply with the requirements of Section 125(i) of the Code must take care to properly communicate the amendments to plan participants and beneficiaries. Employers should timely prepare and distribute summaries of material modifications (SMMs) that advise of amendments to benefit plans. Employers should also review, update, and distribute summary plan descriptions (SPDs) that reflect changes to cafeteria plans and health FSAs.
Fraser Stryker is a leader in tax and employee benefits law. Attorneys in the Firm’s Taxation and Employee Benefits Practice Groups advise individuals, business entities, governments, and nonprofit/tax-exempt organizations on a wide variety of tax and employee benefits matters and transactions. Fraser Stryker works with employers to implement and maintain employee benefit plans that help attract and retain top talent. For more information on health FSAs, please contact Nicole R. Konen.