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The IRS recently issued Notice 2012-40 providing guidance on the
$2,500 limit on salary reduction contributions to health flexible
spending arrangements ("health FSAs") under cafeteria
plans. The $2,500 limit is a new requirement that was added
by the Patient Protection and Affordable Care Act and many plan
sponsors (especially those with non-calendar year plans) have had
compliance questions. The IRS Notice provides clarifications
on several important points.
Limit Applies for Plan Years That Begin After December 31,
2012
The guidance specifies that the $2,500 limit applies on a plan
year basis, not on an employer's or employee's taxable year
basis, and is effective for plan years that begin after
December 31, 2012. This resolves an important issue for
non calendar year cafeteria plans. For example, a cafeteria
plan with a plan year beginning on July 1, 2012 is not required to
apply the $2,500 limit for the plan year that starts on that
date. Instead, the limit will first apply for the plan year
that begins on July 1, 2013.
Limit Applies Only to Employee Salary Reductions Under Health
FSAs
The guidance also clarifies that the $2,500 limit applies only
to employee salary reduction contributions to health FSAs, not to
employer non elective contributions (sometimes called flex credits)
that cannot be cashed out. For example, if an employer
provides $1,000 in non-elective contributions that the employee may
use for any qualified benefit offered under the cafeteria plan, but
cannot be taken by the employee in cash, the $1,000 will not count
against the $2,500 limit on the employee's salary reduction
contributions. On the other hand, if the employer's
$1,000 contribution can be taken by the employee in cash, it will
count against the limit. In addition, the guidance clarifies
that the limit does not apply to arrangements such as employee
salary reduction contributions that are used to pay for the
employee's share of health coverage premiums (sometimes
referred to as premium conversion plans), contributions to health
savings accounts or health reimbursement arrangements.
Grace Period Carryover Not Affected
The effect of a grace period on the $2,500 limit also raised
questions that are resolved by the guidance. If a cafeteria
plan provides for a grace period under which employees may use
amounts remaining in the health FSA from the previous plan year to
pay for qualified expenses incurred during the grace period, unused
amounts that are carried over to the grace period do not count
against the $2,500 limit.
Plan Amendment Due December 31, 2014
The guidance also gives plan sponsors until December 31, 2014 to
amend their cafeteria plans to set forth the $2,500 limit (or a
lower limit chosen by the sponsor), provided the plan is operated
in accordance with the limit for plan years beginning after
December 31, 2012.
Per-Employee and Per-Employer Basis
The $2,500 limit applies on an employee-by-employee basis and an
employer-by-employer basis. For example, if two spouses are
employed by the same employer and each spouse is eligible for the
same cafeteria plan health FSA, each may contribute $2,500.
But the guidance also requires aggregation of health FSA
contributions by all employers in the same controlled group or
affiliated service group, because they are considered a single
employer. For example, an employee participating in two
separate cafeteria plan health FSAs that are sponsored by two
employers in the same controlled group may contribute a total of
only $2,500 to the two health FSAs. But if the two employers
are not related, the employee may contribute $2,500 to each of the
two health FSAs.
Excess Contribution Relief; Change to the Use-It-Or-Lose-It
Rule
Finally, the Notice provides relief for erroneous excess
contributions caused by the plan sponsor's reasonable mistake
if certain requirements are met and requests comments regarding
whether and how the "use-it-or-lose-it" rule should be
modified. A copy of the Notice is available at http://www.irs.gov/pub/irs-drop/n-12-40.pdf.
Practical Tips
Employers should be careful to communicate to employees when
and to what the $2,500 limit applies, so that employees will not be
confused about other amounts that will not count against the limit,
such as grace period carryovers, employer flex credits that cannot
be cashed out, contributions to HSAs or HRAs, or employee salary
reduction contributions to premium conversion plans.
Even though the guidance allows until December 31, 2014 for
plan sponsors to adopt the required amendment, an earlier adoption
could avoid misunderstandings by participants and prevent the
amendment from slipping between the cracks.
Employers that are members of a controlled group of employers
or an affiliated service group should review their administrative
procedures to ensure that they will be able to identify any
employees that are eligible under more than one health FSA
sponsored by related employers and limit the employee salary
reduction contributions accordingly.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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Issues After The Election
