IRS Clarifies Salary Reduction Effective Date for Health FSAs
The IRS clarified the effective date of the $2,500 limit on salary reduction contributions to health flexible spending arrangements (FSAs) under the 2010 Patient Protection and Affordable Care Act (PPACA). Under Notice 2012-40, the IRS also provided guidance on plan amendments and the treatment of certain contributions that mistakenly exceed the $2,500 limit. Taxpayers may rely on the guidance pending issuance of proposed regulations.
CCH Take Away: “The notice brings welcomed certainty concerning the start date," Edward Leeds, counsel, Ballard Spahr, LLP, Philadelphia, told CCH. The tax year is determined with reference to a health FSA’s plan year. “For a health FSA with, for example, a July 1 — June 30 plan year, the limit will first apply to the plan year that begins July 1, 2013,” Leeds explained.
The PPACA provides that a health FSA will not be a qualified benefit under a cafeteria plan unless the plan provides for a $2,500 maximum salary reduction contribution to the FSA. The PPACA adjusts the $2,500 amount for inflation after 2013.
The IRS explained that the $2,500 limit does not apply for plan years that begin before 2013. The term "taxable year" in Code Sec. 125(i), refers to the plan year of the cafeteria plan. Accordingly, the $2,500 limit on health FSA salary reduction contributions applies on a plan-year basis and is effective for plan years beginning after December 31, 2012.
Comment: Information systems and administrative processes need to be modified and annual enrollment communications need to be prepared before 2013 to reflect the $2,500 limit, Leeds observed.
Any effort to delay the effective date through a change of plan years will be restricted. A plan year may be changed only for a valid business purpose. A change from a calendar year to a fiscal year to delay application of the $2,500 is not a change for a valid business purpose, the IRS cautioned. If a cafeteria plan has a short plan year (fewer than 12 months) that begins after 2012, the $2,500 limit must be prorated based on the number of months in that short plan year.
- Amendment: A plan must be amended to reflect the $2,500 limit. A plan amendment may be adopted on or before December 31, 2014, with retroactive effect, as long as the plan has operated in accordance with the new limit, the IRS explained.
- Flex credits: The $2,500 limit does not apply to employer non-elective contributions.
- Grace period: Some plans provide a 2.5 month grace period. Unused salary reduction contributions to a health FSA for the plan year that are carried over into the grace period do not count against the $2,500 limit applicable for the subsequent plan year, the IRS explained.
- Excess contributions: A plan may comply with the written plan requirements set forth under Notice 2012-40 that limit health FSA salary reduction contributions. However, one or more employees may erroneously be allowed to elect a salary reduction of more than $2,500 for a plan year. A plan will continue to be a Code Sec. 125 plan if, among other requirements, the error results from a reasonable mistake by the employer and is not due to willful neglect. Salary reduction contributions in excess of $2,500 must be paid to the employee and reported as wages.
Unused amounts in the health FSA are subject to a “use-or-lose” rule. The IRS is revisiting the rule in light of the $2,500 limitation and requested comments on alternative approaches.
Comment: On May 31, 2012, the House Ways and Means Committee approved legislation (consolidated bill HR 436) to mitigate the use it or lose rule of health FSAs. The bill would allow unspent funds in a health FSA to be distributed as taxable income up to $500.
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