HRS Insight IRS provides guidance on the $2,500 annual limit for FSAs

www.pwc.com
HRS Insight
Human Resource Services
Insight 12/11
June 6, 2012
IRS provides guidance on the
$2,500 annual limit for FSAs
Authored by: Kerry Eason
In brief
IRS Notice 2012-40
provides guidance on
the Affordable Care Act
(ACA) limitation of
$2,500 on annual
salary reduction
contributions to health
flexible spending
accounts (health FSAs).
The Notice clarifies that
the limit applies based
on the plan year of the
cafeteria plan, rather
than on the employer or
employee's tax year,
and is effective for plan
years beginning after
December 31, 2012.
The IRS recently released Notice 201240 providing guidance regarding
implementation of the new $2,500
annual limit on employees' elective
salary reduction contributions to
healthcare flexible spending
arrangements ("health FSAs"), which
was added to the Code by the
Affordable Care Act of 2010 ("ACA").
Importantly, the IRS clarified that the
$2,500 annual limit will be applied on a
plan year basis starting with the first
plan year beginning after December 31,
2012. For plans that apply a grace
period, unused health FSA
contributions for plan years beginning
in 2012 or later that are carried over
into the grace period for that plan year
will not count against the annual dollar
limit in effect for the subsequent plan
year. The annual dollar limit does not
apply to contributions to other types of
FSAs, employer non-elective
contributions, contributions to health
savings accounts ("HSAs") or health
reimbursement arrangements
("HRAs"), or employee pre-tax
premium conversion contributions.
Notice 2012-40 provides relief for
certain contributions that mistakenly
exceed the annual limit due to a
reasonable mistake and not willful
neglect, as long as such excess
contributions are corrected by the
employer in a timely manner.
Plan amendments must be adopted to
reflect the new limit by December 31,
2014.
The IRS also announced its intention to
amend the cafeteria plan regulations to
reflect the annual dollar limit.
Employers and plan sponsors may rely
on this guidance until amended
regulations are issued.
According to Notice 2012-40, the
Treasury Department and IRS are
considering modifying the "use-or-lose"
rule that requires unused amounts in
health FSAs to be forfeited at the end of
the plan year if not used by the
employee; comments are requested on
this issue.
What does tax year
mean?
The ACA requires cafeteria plans to
provide that an employee may not elect
"for any taxable year" to have salary
reduction contributions in excess of
$2,500 made to a health FSA effective
for "tax years beginning after December
31, 2012". Because Congress did not
specify whether the tax year applied to
the employer's tax year, the plan's tax
year or the employee's tax year, the IRS
had to interpret this language. Citing
its proposed cafeteria plan regulations,
the IRS says that the term "taxable
year" refers to the cafeteria plan year.
Accordingly, the annual dollar limit on
salary reduction contributions to health
FSAs applies on a plan year basis, and
is effective for plan years beginning
after December 31, 2012. The $2,500
limit will be indexed for cost-of-living
adjustments for plan years beginning
after December 31, 2013.
Annual limit is per plan;
not an individual limit
The annual dollar limit on
contributions to health FSAs applies on
an employee-by-employee basis, and is
not increased even if the employee's
health FSA covers a non-employee
spouse or other dependents. All
employers that are treated as a single
employer under the controlled group
and affiliated service group rules are
treated as a single employer, and health
FSAs of such related employers are
treated as a single health FSA for
PwC
purposes of this limit. Therefore, if an
employee participates in multiple
cafeteria plans offering health FSAs
maintained by members of a controlled
group or an affiliated service group, the
employee's total health FSA
contributions under all of such cafeteria
plans are limited to $2,500 (as indexed
for inflation). Unlike the elective
deferral limit for 401(k) plans, the
cafeteria plan limit is not an individual
limit. Thus, if an employee is employed
by two or more employers that are not
members of the same controlled group
or affiliated service group, he or she
may elect up to $2,500 (as indexed for
inflation) under each separate
employer's health FSA.
Contributions to which
the limit does not apply
The annual dollar limit does not apply
to employer non-elective contributions
(sometimes referred to as "flex
credits"). Generally, an employer may
make flex credits available to an eligible
employee in the cafeteria plan to be
used (at the employee's election) only
for one or more qualified benefits. For
example, if an employer contributes a
$500 flex credit to each employee's
health FSA for the 2013 plan year, each
employee may still elect to make salary
reduction contributions of $2,500 (as
indexed for inflation) to the health FSA
for that plan year. However, if the
employer provides flex credits that
employees may elect to receive in cash
or as a taxable benefit, those flex credits
are treated as salary reduction
contributions and reduce the amount
the employee could otherwise elect to
contribute to the health FSA.
The annual dollar limit applies only to
the employee's salary reduction
contributions to a health FSA in a
cafeteria plan; it does not limit the
amount permitted for reimbursement
HRS Insight
2
under other employer-provided
coverage, such as employee salary
reduction contributions 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 on a pre-tax basis
(sometimes referred to as "premium
conversion" contributions). Nor does it
apply to salary reduction or other
contributions to health savings account
(HSAs), or to amounts made available
under health reimbursement
arrangement (HRAs).
If a plan applies the optional 2-1/2
month grace period for a plan year,
unused salary reduction contributions
to the health FSA for the plan year that
are carried over into the grace period
do not count against the annual dollar
limit applicable for the subsequent plan
year.
Written plan
amendment required
If a cafeteria plan fails to comply with
the new annual dollar limit for a plan
year beginning after December 31,
2012, the plan is not considered a
cafeteria plan and the value of the
benefits that an employee could have
elected to receive under the plan during
the plan year is includible in the
employee's gross income, regardless of
the benefit elected by the employee.
Under the new IRS guidance, cafeteria
plans must be formally amended to
reflect the $2,500 limit (as indexed for
inflation), and must also comply with
the $2,500 limit in operation.
Generally, cafeteria plan amendments
may be effective only prospectively.
However, the IRS provides relief from
this rule and allows retroactive
amendments, provided amendments
are adopted by December 31, 2014, and
PwC
the cafeteria plan is operated in
accordance with the Code and this new
guidance for plan years beginning after
December 31, 2012.
Limited relief for
erroneous excess FSA
contributions
As long as the cafeteria plan is amended
to comply with the new annual dollar
limit by December 31, 2014, a cafeteria
plan will not be "disqualified" if any
employees are erroneously allowed to
elect salary reduction contributions of
more than $2,500 (as indexed for
inflation) for a plan year. This relief is
available only if: (1) the terms of the
cafeteria plan apply uniformly to all
participants, (2) the error was the result
of a reasonable mistake by the
employer (or the employer's agent) and
was not due to willful neglect, and (3)
salary reduction contributions in excess
of the annual dollar limit in effect for
that plan year are paid to the affected
employee and reported as wages for
income tax withholding and
employment tax purposes on the
employee's Form W-2 for the year of
the correction. Relief is not available
for any plan year for which an
employer's federal tax return is under
examination with respect to benefits
provided under a cafeteria plan.
Changing the plan year
Notice 2012-40 provides that if a
principal purpose of changing from a
calendar year to a fiscal year is to delay
the application of the new annual dollar
limit, the change is not for a valid
business purpose and will not be
recognized. In addition, if a cafeteria
plan has a short plan year that begins
after 2012, the annual dollar limit must
be prorated based on the number of
months in that short plan year.
HRS Insight
3
Request for comments
on possible modification
of use-or-lose rule
The Treasury Department and IRS are
considering modifying the "use-or-lose"
rule for health FSAs, which requires
unused amounts in the FSA to be
forfeited at the end of the plan year if
not used by the employee. While the
IRS recognizes that the new $2,500
limit does not specifically address the
"use-or-lose" rule, the new annual
dollar limit reduces the potential for
using health FSAs to defer
compensation and the extent to which
salary reduction amounts might
otherwise accumulate over time. In
light of this, the Treasury Department
and the IRS are considering whether
the use-or-lose rule should be modified
to provide a different form of
administrative relief (instead of, or in
addition to, the current 2-1/2 month
grace period rule). The IRS asks for
comments by August 17, 2012 on
whether the proposed regulations
should provide additional flexibility
with respect to the operation of the useor-lose rule for health FSAs and, if so,
how any such flexibility might be
PwC
formulated and constrained, and how
any such modifications should interact
with the $2,500 limit.
Observation: The House Ways and
Means Committee recently approved
H.R. 1004, a bill to permit the cash-out
of up to $500 of unused FSA balances
at year end, which would effectively
modify the IRS's use it or lose it rule.
No action is currently scheduled in the
Senate on the companion bill, S. 1404.
Proposed cafeteria plan regulations
were issued in 2007 and have not been
finalized to date. It is unclear when
IRS and Treasury may provide
additional cafeteria plan guidance;
taxpayers may rely on the 2007
proposed regulations and on the
guidance in Notice 2012-40 pending
issuance of amended regulations.
Notice 2012-40 specifically states that
the request for comments on the use or
lose rule does not constitute guidance
and may not be relied upon.
HRS Insight
4
For more information, please do not hesitate to contact your local
PwC professional:
Charlie Yovino
Matthew Cowell
Pat Meyer
Jack Abraham
Paul Perry
Terry Richardson
(678) 419-1330
(704) 344-7739
(617) 530-4722
(646) 471-8855
(617) 530-5694
(312) 298-6229
(312) 298-2164
(312) 298-3157
(312) 298-3717
Cindy Fraterrigo
Brandon Yerre
Theresa Gee
Todd Hoffman
Carrie Duarte
John Caplan
Scott Olsen
Bruce Clouser
Bill Dunn
Amy Lynn Flood
Sandra Hunt
Julie Rumberger
(312) 298-4320
(214) 999-1406
(312) 298-4700
(713) 356-8440
(213) 356-6396
(646) 471-3646
(646) 471-0651
(267) 330-3194
(267) 330-6105
(267) 330-6247
(415) 498-5365
(408) 817-4460
Scott Pollack
Jeff Davis
Nik Shah
(408) 817-7446
(202) 414-1857
(202) 918-1208
Ed Donovan
Atlanta, GA
Charlotte, NC
Boston, MA
New York Metro
Boston, MA
Chicago, IL
Chicago, IL
Chicago, IL
Chicago, IL
Kansas City, MO
St. Louis, MO
Chicago, IL
Dallas, TX
Detroit, MI
Houston, TX
Los Angeles, CA
New York Metro
New York Metro
Philadelphia, PA
Philadelphia, PA
Philadelphia, PA
San Francisco, CA
San Francisco, CA
San Jose, CA
San Jose, CA
Washington, DC
Washington, DC
For more information or to access past issues of HRS Insights, please visit our
website: www.pwc.com/us/hrs
This document is for general information purposes only, and should not be used as a substitute for consultation with professional advisors.
SOLICITATION
© 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, "PwC" refers to PricewaterhouseCoopers LLP, a Delaware
limited liabiity partnership, which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate
legal entity.
PwC
HRS Insight
5