United States: Further Guidance on Cafeteria Plan "Grace Period" Coordination with HSAs

In Notice 2005-86, the Internal Revenue Service provided further guidance regarding implementation of the 2 ½ month grace period for cafeteria plan flexible spending accounts ("FSA") allowed by Notice 2005-42. That earlier Notice relaxed the "use it or lose it" rule that generally allows FSA participants to be reimbursed only for expenses incurred during a plan year, by permitting cafeteria plans to provide a grace period immediately following the end of a plan year during which participants may incur expenses for qualified benefits that may be paid or reimbursed from any unused year-end FSA balance relating to that benefit.

The new guidance primarily addresses the interaction of the FSA grace period with the rules governing eligibility to contribute to Health Savings Accounts ("HSA"). In general, individuals may contribute to an HSA only if they are covered by a high deductible health plan and not by any other health coverage. Following rules set forth in Rev. Rul. 2004-45, the new Notice takes the position that health FSA coverage during the grace period disqualifies an otherwise eligible individual from making HSA contributions for any month beginning in the grace period, unless:

• The health FSA is a limited purpose FSA that covers only preventive care and/or "permitted coverages" such as dental or vision care (see Code sections 223(c)(1)(B) and (c)(2)(C));

• The health FSA is a post-deductible FSA that pays or reimburses preventive care and other qualified medical expenses only after the minimum annual deductible for the high deductible health plan has been satisfied (see Code section 223(c)(2)(A)); or

• The health FSA is a combined limited purpose and post-deductible FSA.

The Notice clarifies that these rules apply whether the health FSA is provided under the cafeteria plan sponsored by an individual’s employer or his or her spouse’s employer.

Unless health FSA coverage is so limited, the Notice requires employers to either:

• Make health FSA participants ineligible for HSA contributions until the first day of the first month following the end of the grace period, in which case the annual HSA contribution limit will be prorated; or

• Limit, on a universal, nonelective basis, health FSA benefits during the grace period to those compatible with HSA coverage. Specifically, for the grace period, the health FSA must be a limited purpose or post-deductible FSA or both for all participants, including participants who have not elected a high deductible health plan.

Transition relief for cafeteria plan years ending before June 5, 2006 allows an individual who participates in a health FSA that offers the grace period, but who is otherwise eligible, to contribute to an HSA for the months beginning in the grace period, provided (i) the participant has no unused health FSA balance at year end, or (ii) the cafeteria plan is amended to exclude from grace period coverage all health FSA participants who elect high deductible health plan coverage for the new year, including any participants who may have participated in, e.g., a limited purpose health FSA for the preceding year.

Notice 2005-86 also amplifies the guidance for the FSA grace period in the following respects:

• The grace period must be available to all participants covered on the last day of the plan year, including by reason of COBRA continuation coverage;

• The maximum grace period is until the 15^th day of the third month after the end of the plan year, although a shorter period may be adopted;

• The grace period remains in effect for its entire term, even for participants who terminate employment during the grace period; and

• Employers may choose to limit the benefits covered during the grace period. For example, if a cafeteria plan offers both a health FSA and a dependent care FSA, coverage during the grace period could be limited only to health FSA benefits.

© 2005 Sutherland Asbill & Brennan LLP. All Rights Reserved.

This article is for informational purposes and is not intended to constitute legal advice.