Modification of the “Use-it-or-lose-it Rule” and the New $500 Carry-forward Option

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October 01, 2018
Author: Christopher G. Stevenson
Organization: Drummond Woodsum

I. Background and Important Term
1. Use-it-or-Lose It Rules and Employees Leaving with Deficits:
As a matter of tax policy, the IRS generally prohibits a service provider from deferring the taxation of compensation received in one year to a subsequent year, except in limited circumstances.15 Consequently, a cafeteria plan, including a health FSA and dependent care assistance plan, is expressly prohibited from providing for a deferral of compensation.16 This general prohibition is manifested in the so-called “Use-it-or-lose-it Rule.”

When an employer offers an FSA (including a health FSA and/or DCAP, although this discussion will focus on health FSAs) under its cafeteria plan, prior to the beginning of the plan year, the employer provides the employee with a salary election form and the employee chooses how much salary he or she wishes to contribute to the FSA for the upcoming year. In 2014, the maximum amount of salary an employee can contribute in a year to a health FSA is capped at $2,500. In addition, the employer can also contribute a uniform amount into each employee’s health FSA over and above the $2,500 cap, subject to applicable IRS nondiscrimination rules.

Once the plan year begins, a pro-rata amount of the employee’s elected contribution to the FSA for the year is withheld from her pay and contributed to the FSA. Funds in the FSA are then held by the employer until paid out to the participant for qualifying health care costs of the participant, his/her spouse and/or dependents. For example, if the employee chooses to contribute $1,300 to her FSA and there are 26 pay periods during the year, each pay period $50 would be withheld pre-tax from the employee’s salary and contributed to the FSA maintained by the employer. As the employee incurs uninsured medical costs throughout the year, the employee pays for those costs using his or her FSA up to the amount of her annual contribution.

Some FSAs provide employees with debit cards to pay for eligible costs at the time they are incurred by the employee. Other plans require the employee to pay for the eligible cost out of his or her own pocket and then seek reimbursement from the FSA account.

One potential draw-back of the FSA, as compared to the HSA, is that the employee can be reimbursed for his medical costs even if she has not yet contributed sufficient salary to her FSA to cover these costs. On the other hand, amounts contributed to an HSA are held by a qualifying trustee, usually a bank, and unused amounts remaining at year-end rollover from year-to-year until the employee uses them. The HSA is portable and travels with the individual even if he/she terminates employment.

For example, if an employee elected to contribute $1,300 to her FSA for the upcoming year and incurs and uninsured medical cost of $1,000 during the second week of the year after contributing only $50 of salary to her FSA, she can receive a reimbursement check for the full $1,000. The employee then continues to contribute $50 of salary for each pay period for the remainder of the year until her total $1,300 FSA contribution for the year is funded. However, if this employee left the employer during the third week of the plan year, after receiving a $1,000 FSA reimbursement but only contributing $50 of salary to her FSA, the employer is liable for $950 the short-fall. Also, IRS rules prohibit the employer from requiring the employee to repay the FSA deficit upon her severance from employment.

However the potential liability under this scenario can be offset by potential forfeitures reverting to employers under the FSA “use-it-or-lose-it” rule. Contributions to an employee’s FSA can generally only be used to pay for qualifying costs incurred by the employee, the employee’s spouse or dependents during the particular plan year (subject to an optional additional grace period of up to 2 ½ months after year-end or an up to $500 carry-forward option discussed below). Under the “use-it-or lose-it rule,” to the extent that the employee has not incurred sufficient medical costs during the plan year and the employee has an unexpended balance in his FSA, the employee forfeits the unexpended balance to the employer (unless the FSA is amended to include an up to $500 carryover option, discussed below). The employer can use the forfeited amounts to pay for future plan administration fees, such as TPA fees, or to offset any shortfalls in employees’ FSA accounts upon their severance from employment.17 Also, under the use-it-or-lose-it rule, if an employee leaves the employer in the middle of the year and as an excess balance in his or her FSA, the excess balance is also generally forfeited to the employer.

Therefore, on balance, the potential liability to the employer from employees leaving the employer in the middle of the year with a deficit in their FSA can be offset by the potential gains reverted to the employer under the use-it-or-lose-it rule. However, the operation of the use-it-or-lose-it rule is obviously unpopular with plan participants can may adversely affect plan participation.

2. Grace Period:
To help alleviate the participant loses under the use-it-or-lose-it rule, a cafeteria plan may be drafted to include a grace period of up to 2 ½ months after year-end where participants may incur additional qualifying medical expenses, dependent care expenses, adoption expenditures to charge against any amounts remaining in the participant’s health FSA, DCAP, or adoption assistance account at the prior year’s end18 (on the other hand, note that the optional $500 carryover option discussed below is only available for health FSAs). Including an optional grace period will reduce participant forefeitures and may increase overall employee participation. On the other hand, those amounts will not be able to offset losses from participants who leave the employer with deficits in their account balances.

Before offering a grace period under a cafeteria plan, a plan sponsor should also consider the following:
1) Grace Period Does Not Equal a Run-Out Period: A run-out period is an additional period of time after year-end or after-year end, plus the Grace Period, whereby participants have to remit claims for expenses incurred during the prior year. Expenses incurred during the run-out period are not eligible for reimbursement from prior year balances. Employers can use a different run-out period for different plan benefits (health FSA and DCAP).

2) Optional: Offering a grace period is optional, not mandatory.

3) Plan Document: The grace period must be expressly provided for in the plan document.
Plan documents may need to be amended.

4) No Retroactive Plan Year Amendment: A plan sponsor must amend the plan document before the end of the current plan year in order to be effective for that plan year. Participants should be notified promptly upon the addition or deletion of a grace period (Summary of Material Modifications).

5) No Mix and Match of Benefits: Amounts remaining in a health FSA at year-end cannot be used to reimburse DCAP expenses or vice-versa and this prohibition must be provided for in the plan document.

6) Universal Availability: A grace period must be open to all participants, including COBRA enrollees. For example, if an employee is terminated mid-year and elects health FSA COBRA coverage under plan that includes a grace period, the individual must be able to seek reimbursement during that grace period. If the terminated employee had participated in a health FSA during employment but did not elect health FSA COBRA coverage, he/she would not be eligible for health FSA coverage during the grace period (unless he/she was terminated during the grace period). If the employee’s employment terminates during the grace period, he must be offered FSA coverage during the grace period, even if he does not elect COBRA coverage under the FSA.

Example: Employee elects $1,200 of FSA coverage for 2014 and his employment terminates on September 1, 2014. If a grace period is provided under the FSA for 2014, it will not apply to the employee unless he elects COBRA coverage under his FSA for 2014 and is receiving coverage as of December 31, 2014. If the termination happened January 15, 2015, the grace period would apply to the employee assuming he had FSA coverage as of December 31, 2014.

7) Grace Period Available to Employees Dropping Coverage: If an employee decides not to re-enroll in the health FSA in the upcoming year any amount remaining in the employee’s account at the end of the prior year is still available to the employee through the end of the subsequent grace period.

Example: Employee elects $1,200 of FSA coverage in 2014 but does not re-enroll in 2015. At the end of 2014 she has $200 left in her FSA. If the FSA has a grace period, the $200 will be available during that grace period in the beginning of 2015.

8) Dollar Limit is Permitted, Percentage Limit Is Not: The grace period provision may limit the amount of unused benefits or contributions available during the grace period based upon a certain maximum dollar amount (e.g. $250) but not based upon a percentage of unused benefits. Also, any limit must apply to all participants.

9) FIFO/LIFO: The applicable rules do not specify whether costs incurred during a grace period must first be charged to the prior year health FSA contributions or to the current year contributions. The plan sponsor may choose to draft the plan to apply expenses incurred during the grace period first against any prior year unexpended balance, and then against any current year balance or vice-versa. Also, the plan sponsor may draft the plan such that the allocation of expenses occurs after the end of the grace period.

Example: Assume the employer has a calendar year FSA with a grace period that ends March 15th. Employee contributes $1,200 of FSA coverage for 2014 and has $200 left at calendar year end. The employee contributes another $1,500 of coverage for calendar year 2015. If the employee incurs $300 of additional expenses during the run-out period the FSA may be drafted to apply those expenses first to use up the $200 remaining at the end of 2014, with the $100 balance then applied to 2015’s coverage. This could create an adverse result if prior to the end of 2014’s run out period, the employee presented additional qualifying expenses that were incurred during 2014. On the other hand, the FSA could be drafted to wait until after the end of 2014’s grace period to allocate such expenses.

10) Excess Medical Premium Deductions: A grace period could allow a participant who changed his/her health insurance coverage mid-year to a less expensive option, but did not have a qualifying change of status event, to use the excess medical premium withholdings for the balance of the plan year to pay for coverage during the subsequent grace period. For example, if an employee switches from employee plus one coverage to employee-only coverage effective November 1, without incurring a qualifying change of status event the employee is still required to withhold the employee’s share of the premium for employee plus one coverage for the last two months of the year but could use that excess withholding to fund the employee’s cost of coverage during the subsequent grace period.

11) Grace Periods for Select Benefits Permitted: A plan sponsor may adopt a grace period for certain benefits under its cafeteria plan but not others. For example, an employer that sponsors both a health FSA and a DCAP may limit the grace period to the health FSA.

12) DCAP Grace Period Amounts Count Toward $5,000 Maximum: DCAP carryover amounts count toward the employee’s maximum DCAP exclusion for the year that the amount is carried into.

Example: Employee is single with a maximum DCAP exclusion of $5,000. At the end of 2014 he had $200 of unused DCAP expenses that carried over into 2015. In 2015 he contributed, and incurred, an additional $5,000 of DCAP expenses. Of the total $5,200 of DCAP reimbursements during 2015, $200 is taxable

13) Unused Amounts are Forfeited: Any amounts remaining unused at the end of the grace period must be forfeited to the plan sponsor.

14) Grace Period Can Block HSA Participation: An individual with a balance in his/her FSA at year-end and who is eligible for FSA reimbursement during a grace period (or a spouse whose medical expenses are eligible for reimbursement under the health FSA) cannot make contributions to an HSA during that grace period but must wait until the first day of the month following the end of the grace period. This can be a problem where an employee switches from traditional health insurance coverage with an FSA to high-deductible health insurance coverage with and HSA. However the HAS rules allow a participant to accelerate contributions for the balance of the HSA plan year, following the end of the FSA grace period, so that the participant is able to contribute the HSA maximum for that first year of eligibility.19 For example, if the employee switches to a HDHP effective January 1, 2015 but had participated in a traditional medical insurance plan and health FSA, with a 2-month grace period, for the year-ending December 31, 2014, the employee could switch to a HDHP effective January 1, 2015 and begin contributing to a HSA effective March 1, 2015.

Also, if an employee does not have any amounts left in the FSA at year-end, the individual would not be blocked from switching to an HSA in the upcoming year, even if the FSA included a grace period. Finally, an employer could amend the health FSA to convert grace period coverage to an HSA-compatible arrangements for the period of the grace period such as a limited purpose FSA (may reimburse only dental, vision, and preventative care expenses) or a post-deductible FSA (that provides coverage only after the HDHP minimum deductible has been satisfied. Such a conversion must apply to all grace period participants.

15) Grace Period Does Not Affect health FSA Status as Excepted Benefit: In order for an health FSA to be considered and excepted benefit, the total benefit payable under the health FSA cannot exceed two times the participant’s salary reduction. IRS officials have informally indicated that benefits provided during a grace period will not be included in the calculation.

16) DCAP W-2 Reporting: DCAP benefits are reported in box 10 of Form W-2. If not all DCAP claims have been submitted by the time the W-2 is prepared, the IRS allows employers to use reasonable estimates.20 The IRS allows employers to use an amount equal to the employee’s salary reduction for the year, even if the DCAP includes a grace period.21 For example, if the DCAP includes a two-month grace period and an employee had contributed $5,000 to his DCAP for the 2015 plan year but as of December 31, 2015 the employee had only used $4,800 of that amount, the employer may estimate that all $5,000 would be used by the end of the grace period and therefore report the employee’s 2015 DCAP benefit as $5,000 on Form W-2.

Note that if an employee’s total DCAP expenditures for the year, including amounts incurred during the previous year’s grace period exceed the total DCAP exclusion ($5,000), the excess is taxable to the employee. For example, employee has $100 of excess DCAP benefits at the end of 2013, which are to reimburse qualifying expenditures during the 2 and ½ month grace period following year-end. The employee contributes, and uses, another $5,000 to his DCAP account for 2014, the $100 of excess dependent care expenses are taxable income to the employee.

17) Debit Cards: If the plan includes a grace period and uses a debit card, plan sponsors should check with the debit card provider regarding whether the technology allows participant’s to seek reimbursement for grace period amounts. It may be that grace period expenditures have to be reimbursed manually. If so, plan sponsors should communicate this to participants.

3. New $500 Optional Carryover Provision
In 2013, the IRS announced that employers can amend their health FSA’s to allow up to $500 of a participant’s Health FSA balance at year-end to be carried forward and eligible to reimburse the participant’s uninsured medical costs in the upcoming year.22 This new $500 carryover option is only available for health FSAs (e.g. it is not available for DCAP). The $500 carryover is optional and is an alternative to a grace period and cannot be offered-in-conjunction with a grace period other. In other words, if an employer currently offers a health FSA that includes a optional grace period, the employer would have to amend the health FSA to remove the grace period in order to be able to offer the $500 health FSA carryover.

Before offering a grace period under a cafeteria plan, an plan sponsor should also consider the following:

1) Timing: Amendments to add the carryover feature must generally made by the end of the plan year from which amounts can be carried over. For example, an employer cannot amend the plan in January of 2015 in order to allow carryovers from 2014. The amendment would have to be made by December 31, 2014. However, in a special rule, employers have until the last day of the 2014 plan year to amend the plan to allow carryovers from 2013. In addition, if the current plan contains a grace period, care must be taken regarding timing of amendments. Unlike the $500 carryover, there are no limits (unless a plan sponsor expressly includes a limit in the plan document) to the amount of a health FSA balance that is available during the grace period. Therefore, an employee may object if an employer amends a plan in December of 2014 to remove the grace period for the 2014 plan year and add a $500 carryover (if for example, the employee was planning on leaving $1,000 at year-end for use during the subsequent grace period. A better approach would be to amend the plan, prior to 2014 and communicate the change to employees at that time.

2) Advance Notice: Employees must be given advance notice when a carryover is added. Waiting to include the notice in the SMM would be too late, although an SMM would still be required to be sent to employees regarding the change.

3) Maximum Reimbursement: Any carryover into a subsequent year does not reduce the maximum health FSA reimbursement available in that year. The maximum health FSA reimbursement for a given year cannot exceed: (i) up to $2,500 (indexed) in salary reductions, (ii) any non-elective, employer flex credits, and (iii) up to $500 in carryover.

4) Employee Termination:
 If an employee terminates, he forfeits any carryover amounts unless he/she elects health FSA COBRA. However, the former employee should be allowed in any event to seek reimbursement for expenses incurred prior to the termination date (or through the end of the month that includes the termination date, if the plan is drafted as such).

5) Timing: The IRS guidance allows flexibility with respect to whether to pay claims from carryover amounts first or after current year contributions. If the employee has $500 or less of unused amounts at the end of the plan year, the best practice is probably for employers to pay qualifying expenses first from current year health FSA contributions and then from any carryover amount. If for example, any employee has $500 of unused amounts at the end of 2014 and incurs $400 of qualifying expenses in January of 2015, the health FSA should be drafted to apply the reimbursement first from the 2015 salary deferrals. This way the $500 carryover from 2014 is preserved for any 2014 expenses that the employee subsequently submits during the 2014 grace period. Alternatively, the applicable rules would allow the employer to have the employee specify which source of funds any such reimbursement was made from. However, administering such a feature may increase burdens on the plan sponsor.

6) Mutually Exclusive: After year-end, a health FSA cannot offer both a grace period and a carryover that extends into the following year. On the other hand, for example, if a health FSA included a grace period for the 2013 plan year that extended into 2014, the plan could be amended before the end of 2014 to remove the grace period and instead allow for a carryover option from 2014 and into 2015.

7) Indefinite Carry-forward: If an employee carries over $500 from 2013 to 2014 and at the end of 2014, amounts remain available; they are carried over into 2015. This is the case even if the employee does not elect to contribute to the health FSA in 2015. The excess amounts are not forfeited.

8) HSA Ineligibility: A carryover to a general purpose health FSA into a subsequent year blocks the individual from participating in an HSA for the entire subsequent year (as compared to a grace period which blocks the employee from the HSA only for the grace period’s duration. However, an employer could amend the health FSA to provide that the carryover amount is rolled over into an HSA-compatible limited purpose FSA (may reimburse only dental, vision, and preventative care expenses) or a post deductible health FSA (that provides coverage only after the HDHP minimum deductible has been satisfied) in order to allow the individual to contribute to a HSA for the year in question.

9) W-2 Reporting: Health FSA coverage is generally not required to be reported on an employee’s Form W-2 unless the amount of the employee’s health FSA exceeds his/her FSA contributions. The IRS has informally commented that carryovers would not cause the health FSA to be reported on Form W-2.
10) Ordering: During a health FSA’s run-out period, potential carryover amounts may be used either for prior year or current year claims, although no more than $500 in potential carryover can be used to reimburse current year expense. During this time plans may reimburse current year expense first from current year contributions, preserving the potential $500 carryover. This would allow the $500 carry over to be available if the participant presents additional qualifying reimbursements for the prior year.

Example: Health FSA allows for a $500 carryover and has a 2-month run-out period following year end. Employee contributes $1,500 toward health FSA coverage in 2014 but as of December 31, 2014 has $500 of unused amounts. Employee contributes an additional $1,500 for 2015. In January of 2015 employee submits $500 of expenses incurred in January of 2015. Employee’s health FSA plan charges those expenses against employee’s 2015 FSA contribution, preserving the $500 carryover into 2015. In February of 2015, employee presents $500 of qualifying expenses from 2014. The $500 carryover from 2014 is available to reimburse those costs.

Example: Same facts as above, except that employee has $800 left at the end of 2014. This leaves him with $800 available for prior year claims submitted during the 2015 runout period or up to $2000 for amounts incurred during 2015 ($1,500 salary reduction plus $500 carryover).

15 See generally 26. U.S.C. §409A
16 26 U.S.C. §125(d)(2).
17 Prop. Treas. Reg. §1.125-5(o).
18 Prop. Treas. Reg. §1.125-1(e) and IRS Notice 2005-42.
19 26 U.S.C. §223(b)(8).
20 IRS Notice 89-111.
21 IRS Notice 2005-61.
22 IRS Notice 2013-71

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