Employers around the country are waking up to a serious and unexpected problem with their health care flexible spending accounts. The health reform law enacted several years ago quietly limited these popular “FSA” benefits to $2,500 per year, effective January 1, 2013. But the express terms of the law conflict with the explanation provided by Congress, and many employers have been scratching their heads trying to figure out when plans must be changed to meet the requirements of the new law, and what amendment language must say.

Last week, the IRS issued long awaited guidance which answers many of the questions surrounding the new limit (Notice 2012-40). The Notice also may open the door for addressing some policy issues built into the deferral ceiling.

Here’s the problem: The law says that FSAs are not “qualified” under tax law unless the plan provides that an employee’s salary deferral to fund the FSA does not exceed $2,500 “for any taxable year” beginning after December 31, 2012. “Qualified” status is important because if an FSA is not qualified, benefits payable under the plan become taxable income.

The $2,500 limit seems simple enough, and for FSAs that operate on a calendar year basis, it is. The taxable year for virtually all employees is the calendar year, and if an employer sponsors an FSA that runs from January 1, 2013 to December 31, 2013, employee salary deferrals must be limited to $2,500 during that period. In addition, plan amendments imposing the new limit will need to be in place by December 31, 2012 so that the plan remains qualified. But what about a plan that runs on a fiscal year that encompasses the effective date of the new law, say July 1, 2012 to June 30, 2013?

In this case, can the employee take advantage of unlimited salary deferrals until December 31, 2012, but then make sure the total of his or her deferrals in 2013 does not exceed $2,500? That would require the employer to keep track of an employee’s 2013 deferrals for six months in the plan year ending June 30, 2013, and for the first six months of the next plan year beginning July 1, 2013. A deferral election for the plan year beginning July 1, 2012 could affect how much a participant can defer in the following plan year beginning July 1, 2013. In some cases, the new limit also would require a change in the employee’s deferral elections after December 31, 2012, so that the 2013 $2,500 limit is met.

Or, does the plan sponsor only have to worry about an election to defer made after December 31, 2012, making sure that the election is limited to $2,500 for the plan year beginning in 2013? This was the view of Congress in the committee report that accompanied the health reform law. If this is the case, employers need only worry about elections made for plan years beginning after December 31, 2012. For the July 1 plan mentioned above, that would be effective July 1, 2013. Further, the amendment would not have to be made until June 30, 2013.

Last week’s IRS guidance indicates the $2,500 limit will apply to the FSA’s plan year beginning in 2013. That means, in the case of the year ending June 30, 2012, the new limit is effective for deferrals on and after July 1, 2013. Employee elections for the 2012 – 2013 year will remain in place for the entire plan year, and the FSA will be administered in the 2012 – 2013 year without the new limit.

Plan amendments incorporating the new limit do not have to be adopted until the end of calendar year 2014. The extended date relieves the pressure on plan sponsors and administrators to amend plans for the limit within the next seven months. Before amendment, FSAs must be operated consistently with the new ceiling one it is effective so the plan will remain qualified. If the limit is inadvertently exceeded, the Notice provides a relief mechanism for correcting the excess and avoiding disqualification of the plan.

FSAs generally allow a grace period (up to two months and 15 days) following the end of the plan year for employees to utilize unused deferrals. The guidance clarifies that grace periods will continue to apply, and that amounts used from a prior year during the grace period will apply to the prior year limit.

Some commentators have suggested that aggressive plan sponsors might amend the FSA fiscal year to adopt a period beginning mid calendar year to delay the effect of the $2,500 limit. For example, if the FSA fiscal year were changed to a December 1 though November 30 period in 2012, the new limit would not apply until December 1, 2013 – effectively granting employees almost another full year with unlimited deferrals. However, existing 125 plan regulations require a valid business purpose for a plan year change. The Notice specifies that modifying the FSA’s fiscal year to delay the effective date of the $2,500 ceiling is not a valid business purpose.

As a matter of policy, many plan sponsors have expressed concern that the ceiling on FSA deferrals will have a real and negative fiscal impact on high deferral employees – these employees depend on FSAs to help defray the cost of special medical needs, and to lessen the effect of escalating health care costs and high deductible plans. The IRS has acknowledged this concern in part by inviting comments in light of the $2,500 limit on the use it or lose it rule (unused deferrals are lost to the employee if not used by the end of the annual grace period.) While it’s unlikely the use it or lose it rule will be scrapped, the Notice indicates the IRS is considering additional flexibility for the grace period, and also may be open to other forms of administrative relief. The comment deadline is August 17, 2012.

For more information, contact Robert C. Christenson, partner at Fisher & Phillips LLP at rchristenson@laborlawyers.com or (404) 240-4256, or Stuart O. Baesel Jr., of counsel, at sbaesel@laborlawyers.com or (404) 231-1400.

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