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'Use It Or Lose It?' Not Necessarily... A Closer Look at the Recent IRS Guidance on Flexible Spending Accounts


The following article was originally prepared by Crowell & Moring, LLP on behalf of the American Benefits Council.

On October 31, 2013, the Internal Revenue Service (IRS) released Notice 2013-71 (Guidance), which modifies the existing "use-it-or-lose-it" rule for health flexible spending accounts (FSAs) set forth in proposed regulations under Section 125 of the Internal Revenue Code (Code) to allow for a limited "carryover."

Under the Guidance, cafeteria plans under Code Section 125 can be amended to allow up to $500 of unused amounts remaining at the end of a plan year in a health FSA to "carry over" and be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year, provided that the plan does not also incorporate the two-month, 15-day "grace period" allowed under current IRS guidance. The carryover of up to $500 does not affect the maximum amount of salary reduction contributions that the participant is permitted to make under Code Section 125(i) (currently $2,500 adjusted for inflation).

The Guidance also provides clarification of transition relief that applies to Code Section 125 plans with non-calendar-year plan years beginning in 2013. The transition relief gives employees participating in such plans expanded flexibility to make changes to their salary reduction elections.

The availability of the carryover rule will provide increased flexibility for employers with respect to plan design and, if adopted, will enable employees to avoid forfeitures of certain unused amounts. Nonetheless, certain issues are left unaddressed by the Guidance, including how the carryover rule could affect an individual's eligibility to make contributions to a Health Savings Account (HSA), as well as the potential implications of replacing a planned grace period for 2013 with the FSA carryover rule. Employers should carefully consider these issues in deciding whether to adopt the carryover rule for the 2013 plan year (and for 2014 and beyond), or to wait until further guidance is issued.

This Blueprint provides background on the prior rules relating to FSAs, summarizes the new Guidance, and discusses some of the open issues that employers will have to consider.

Background on FSAs

A health FSA is any employee- or employer-funded account designed to reimburse employees for certain medical care expenses. FSAs are typically funded by employee contributions through a salary reduction agreement, although employers can also contribute to FSAs on behalf of their employees. Contributions made to an FSA offered through a Code Section 125 cafeteria plan (which allow an employee to choose between cash or "qualified benefits") do not result in gross income to the employee.

Under Code Section 125(d)(2)(A), a Code Section 125 cafeteria plan generally does not include any plan that provides for deferred compensation. Therefore, FSAs offered through a cafeteria plan had to incorporate the infamous "use-it-or-lose-it" rule, which requires that any amounts in the FSA that are unused as of the end of the plan year (or a limited "run-out" period after the plan year, if applicable under the Plan terms) be forfeited.

In 2005, the Department of the Treasury and the IRS adopted one modification to the use-it-or-lose-it rule by implementing a limited "grace period" rule. Under the grace period rule, a Code Section 125 cafeteria plan may permit an employee to use amounts remaining in an FSA from the previous year to pay expenses incurred during a period that extends no later than two months and 15 days immediately following the end of the plan year (i.e. March 15 for a plan with a calendar plan year).

The Patient Protection and Affordable Care Act (PPACA) added Section 125(i) to the Code. Under Code Section 125(i) and subsequent IRS guidance, beginning with the first day of the first plan year beginning in 2013, a health FSA is not treated as a qualified benefit unless the Code Section 125 cafeteria plan limits each employee's salary reduction contributions to the health FSA to no more than $2,500 per taxable year (as indexed for inflation). In Notice 2012-40, the IRS observed that this new statutory requirement "limits the potential for using health FSAs to defer compensation and the extent to which salary reduction amounts may accumulate over time. Notice 2012-40 further stated that, given the $2,500 limit, the Treasury Department and the IRS were considering whether the use-or-lose rule for health FSAs should be modified to provide a different form of administrative relief instead of, or in addition to, the current 2½ month grace period rule." The resulting administrative relief is set forth in the Guidance.

Summary of FSA Carryover Guidance

Under the Guidance, an employer may amend its cafeteria plan to provide for a carryover to the immediately following plan year of up to $500 of any amount in a health FSA remaining unused as of the end of the plan year. The carryover of up to $500 may be used to pay or reimburse eligible medical expenses incurred during the entire plan year (or plan years) to which it is carried over. In other words, if a plan operates on a calendar year, and $200 remains in the FSA at the end of 2013, the plan could be amended to provide that the remaining $200 is carried forward into 2014 and, as such, could be used to pay or reimburse medical expenses incurred any time in 2014. Any unused amount that is in excess of $500 (or a lower amount if specified in the plan) would be forfeited. In addition, any unused amount remaining in an employee's FSA as of termination of employment is also forfeited, without regard to the carryover rule (unless the employee elects COBRA continuation coverage with respect to the FSA).

Comment: The Guidance is not entirely clear if amounts that are "carried over" are only carried over for one plan year (in which case such amounts would presumably be forfeited at the end of the plan year), or whether they can be carried over indefinitely until the employee terminates employment or loses coverage under the FSA.

However, "Example 4" provided in the Guidance strongly suggests that amounts can be "carried over" indefinitely while the employee remains FSA-eligible. In the relevant example, an employee elects a salary reduction of $600 for 2014 and, as of the end of the 2014 plan year, still has $600 in his FSA. The employee then elects no salary reduction for 2015. $100 would be forfeited because it is over the $500 limit, and $500 would carry over for the 2015 plan year. After incurring $200 in expenses during 2015, as of December 31, 2015, the employee has $300 in his FSA. The example suggests that the employee can carry over the $300 for the 2016 plan year and use it to reimburse medical expenses incurred in 2016.

The Guidance also is not clear regarding whether an employer could adopt a plan-specific rule that would "cut off" the carryover after a set period of time. For example, an employer might want to adopt a rule providing that up to $500 can be carried from one plan year to the immediately following plan year, but that the carried-over amounts would be forfeited at the end of that following plan year.

Lastly, to the extent that an employer provides for non-elective employer contributions or "flex" credits to the FSA, there is a possibility that such amounts could cause an employer's FSA to no longer be HIPAA-excepted if the employer contributions and the carryover amount result in the account balance exceeding the greater of twice the amount of the employee's salary deferrals or $500. While we suspect the regulators will resolve this issue in future guidance, for the time being, this issue remains.

Although the maximum unused amount allowed to be carried over in any plan year is $500, the plan may specify a lower amount as the permissible maximum in its plan document (or the plan sponsor could simply not permit any carryover at all).

Comment: Given the administrative complexities associated with the carryover rule, questions have also arisen regarding whether an employer's plan could be amended to provide that only FSA account balances exceeding a certain dollar threshold are eligible for carryover. The Guidance does not explicitly prevent employers from adopting such an approach, but it does not address whether such an amendment would be permissible, either. To the extent permitted, plan administrators could avoid having to track small carryover amounts that roll over in employees' accounts from year to year.

The amount remaining unused as of the end of the plan year that can be "carried over" is the amount unused after medical expenses have been reimbursed at the end of the plan's run-out period for the plan year. In addition to the "carried-over" amounts, the plan may permit the individual to also elect up to the maximum allowed salary reduction amount under the Code. Therefore, the "carried over" amounts do not affect the $2,500 salary reduction limit (as adjusted for inflation). However, the plan cannot allow an individual to contribute more than $2,500 (via salary reduction and as adjusted for inflation) or reimburse claims incurred during the plan year that exceed the $2,500 limit (as adjusted for inflation) plus the carryover limit of up to $500. If an employer amends its plan to adopt a carryover rule, the same carryover limit must apply to all plan participants. Finally, as under prior rules, the Guidance reaffirms that a Code Section 125 cafeteria plan is not permitted to allow unused amounts relating to an FSA to be cashed out or converted to any other taxable or nontaxable benefit.

FSA Carryover and Implications for HSA Eligibility

Statutory and regulatory rules governing HSAs generally require that for individuals to be eligible to make HSA contributions, they must be enrolled in qualifying high-deductible health plan (HDHP) coverage and not have other coverage. If an employee has access to a general-purpose FSA (that reimburses almost all health and medical expenses), it is considered a health plan that disqualifies the employee from being able to contribute to an HSA. Therefore, employers that amend their cafeteria plans to allow amounts in employees' FSAs to "carry over" from one plan year to the next may, in the process, limit an employee's ability to participate in the HSA program.

Comment: Employers that sponsor an HDHP option intended to permit employees to contribute to an HSA will want to be very cautious about adopting a carryover feature for their FSA.

For example, assume Employee X elects a salary reduction of $2,000 for her FSA in 2014, and, as of December 31, 2014, she has $50 remaining in her FSA. Also, assume that her employer amended the cafeteria plan to provide that the carryover rule will apply to unused FSA amounts.

If Employee X wishes to change her benefit election and make contributions to an HSA in 2015, it appears that she may not be able to do so under current law. This is because she could be found to still be participating in the employer-sponsored FSA in 2015 (since her unused FSA amounts would have automatically carried over) and therefore apparently be HSA-ineligible, even if she does not elect any salary reduction for the FSA in 2015. Also unclear is whether (i) Employee X would be ineligible for HSA participation for the entire FSA plan year of the carryover (i.e., 2015), or whether the ineligibility would cease as of the first day of the next month after she spends down the carried-over amount to $0, and (ii) whether her mere eligibility for the carryover would have the effect of making her ineligible to contribute to an HSA for 2015 regardless of whether her FSA balance is $0 as of December 31, 2014.

An employee generally can remain HSA-eligible if the employee participates in either a "limited-purpose" FSA or a "post-deductible" FSA. Under a limited-purpose FSA, eligible reimbursable expenses are limited to preventive care and qualifying dental and vision expenses. A post-deductible FSA pays or reimburses preventive care and other qualified medical expenses only if the expenses are incurred after the minimum annual deductible for the HDHP is satisfied.

Questions have arisen regarding whether an employer could amend its cafeteria plan to provide that amounts that are "carried over" from a general-purpose FSA will be "carried over" into a limited-purpose or post-deductible FSA. This would allow employees to remain HSA-eligible in subsequent years notwithstanding the carryover feature Although the IRS may address this issue in further guidance, such guidance may not be available before the end of 2013. In the interim, we believe employers that plan on offering an HDHP option in 2014 should proceed carefully, and they may want to delay amending their cafeteria plans to adopt a carryover feature until additional guidance is received.

Ordering Rule

A plan adopting the carryover rule is not permitted under the Guidance to also use the "grace period" rule for health FSAs. However, as noted above, any health FSA can provide for the reimbursement of expenses incurred in one plan year during a permitted run-out period. Therefore, for plans that are amended to provide for a carryover rule, a participant's unused health FSA balance at the end of the prior plan year may be used either for expenses incurred in the prior plan year, but only if claimed during the plan's run-out period that begins at the end of the prior plan year, or to the extent of the permitted carryover amount from the prior plan year, for expenses that are incurred at any time in the following plan year.

In the interest of administrative simplicity, a cafeteria plan utilizing the carryover rule can treat reimbursements of all claims for expenses that are incurred in the current plan year as reimbursed first from unused amounts credited for the current plan year and then reimbursed from amounts carried over from the preceding plan year. Any unused amounts from the prior plan year that are used to reimburse a current year expense will reduce the amounts available to pay prior plan year expenses during the run-out period.

Comment: "Example 2" in the Guidance demonstrates how this ordering rule would work. In the example, an employee has an unused amount of $800 in his FSA as of the end of 2014, and elects a salary reduction amount of $2,500 for 2015. The employee then incurs expenses of $2,700 in January 2015. The plan would treat the first $2,500 of the claim as reimbursed with health FSA contributions for 2015, and the remaining $200 of the claim as reimbursed with the unused amounts as of December 31, 2014. However, $600 ($800 minus $200) remains available to pay claims for expenses incurred during the 2014 plan year (since the 2014 run-out period is continuing during early 2015). The example makes clear that only $500 of the $800 unused amount as of December 31, 2014 is available to pay 2015 expenses. (Example 2 also identifies the carryover amount for 2014 and 2015 plan years).

Plan Amendment

A Code Section 125 cafeteria plan wishing to take advantage of the new carryover rule must be formally amended to incorporate the carryover provision. The Guidance requires the amendment to be adopted on or before the last day of the plan year from which amounts may be carried over, and the amendment may be effective retroactively to the first day of that plan year. However, if the amendment is retroactive, the plan must also operate in accordance with the Guidance and inform participants of the carryover provision.

Under a special transition rule, a plan may be amended to adopt the carryover rule for a plan year that begins in 2013 at any time on or before the last day of the plan year that begins in 2014. If the plan currently provides for a grace period and is being amended to add the carryover rule, the plan must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over.

Comment: The Guidance notes that "the ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal constraints." We note that employers should be aware that adopting an amendment that provides for a carryover, but eliminates a grace period, could disadvantage certain employees. For example, an employee might plan to have surgery in January 2014 intending to use $1,000 of his FSA balance in January 2014 to pay for related expenses during the grace period that runs from January 1, 2014 to March 15, 2014. If the employer amended the cafeteria plan to eliminate the grace period in favor of the carryover rule, the employee would only have $500 for use instead of the full $1,000.

It is not clear to us that there would be a claim under the Employee Retirement Income Security Act of 1974 (ERISA) against the employer in such a circumstance, since amending the plan is a settlor action that is not subject to ERISA's fiduciary restraints. At a minimum, this scenario could adversely affect employee relations. Plans that have already communicated that a grace period will apply for the 2013 plan year may want to consider delaying implementation of a carryover rule so that employees are given adequate time to plan accordingly.

Clarification of Transition Rule for Participant Changes in Salary Reduction Elections

Code Section 125 cafeteria plan elections generally must be made before the start of the plan year, and they are irrevocable during the plan year, with limited exceptions, including certain changes in status. Under federal regulations, the availability of health plan coverage through an Exchange beginning in 2014 does not appear to trigger a new cafeteria plan election. As a result, employees participating in a non-calendar-year plan year cafeteria plan may not be able to change their salary reduction elections for health coverage in the middle of a plan year in the event they elect to purchase coverage through an Exchange.

Under transition relief included in proposed regulations implementing the PPACA's shared responsibility provisions (Code Section 4980H), an employer could elect to amend a non-calendar-year plan year cafeteria plan to allow employees to make either or both of the following changes in salary reduction elections, regardless of whether the employee experienced a change in status event:

  1. An employee who elected to reduce salary through the cafeteria plan for accident and health plan coverage could prospectively revoke or change his election with respect to the accident and health plan once during the plan year beginning in 2013; and
  2. An employee who failed to make a salary reduction election through the cafeteria plan for accident and health plan coverage prior to the deadline for the plan year beginning in 2013 is allowed to make a prospective salary reduction election for accident and health coverage on or after the first day of the 2013 plan year.

The Guidance clarifies that this transition relief applies to all employers that sponsor a non-calendar-year plan year cafeteria plan. (Since the relief was issued as part of the Code Section 4980H regulations, which only apply to "applicable large employers" with 50 or more full-time equivalent employees, it appeared on its face to not apply to smaller employers. The Guidance clarifies that this is not the case.)

In addition, the Guidance clarifies that an employer can adopt an amendment to a cafeteria plan that is more restrictive than provided by the transition relief, but not less restrictive. For example, an employer could amend its cafeteria plan to allow an employee who elected to reduce salary through the cafeteria plan for the non-calendar-year plan year beginning in 2013 to prospectively revoke or change his election with respect to the accident and health plan only during a limited period – for example, the first month of 2014 only, rather than the entire plan year.

Comment: Note that this transition relief applies only to cafeteria plans that operate based on a non-calendar-year plan year. Many employers that sponsor cafeteria plans that operate on a calendar plan year are similarly interested in whether they could allow employees to change their elections during the plan year, so that an employee (or one of the employee's dependents) could switch from employer-sponsored coverage to coverage through an Exchange. The Guidance does not address this concern.


IRS CIRCULAR 230 NOTICE: As required by the Internal Revenue Service, we inform you that any tax advice contained in this document was not intended or written to be used or referred to, and cannot be used or referred to, (i) for the purpose of avoiding penalties under the Internal Revenue Code, or (ii) in promoting, marketing or recommending to another party any transaction or matter addressed in this document.

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