HUMAN CAPITAL PRACTICE
ALERT:
HEALTH CARE REFORM BILL
June 2012
www.willis.com
GUIDANCE ISSUED ON
$2,500 HEALTH FSA LIMIT
The Internal Revenue Service (IRS) has issued guidance regarding the $2,500 limit on
employees’ pre-tax contributions to health flexible spending accounts (FSA). The limit was
enacted in 2010 as part of the federal health care reform law, and Notice 2012-40 provides
guidance employers need for implementing it, including the effective date, the time limit for
amending plans, and what happens if too much is mistakenly contributed.
EFFECTIVE DATE
Under §125(i) of the Internal Revenue Code (IRC), “an employee may not elect for any taxable
year to have salary reduction contributions in excess of $2,500 made to” a health FSA. The
effective date stated in the health care reform law was any tax year beginning after 2012, and it
seemed clear that this referred to the employee’s tax year (i.e., the calendar year). As a result,
experts concluded that the statute required implementing the limit on a calendar-year basis for
all plans starting January 1, 2013, regardless of the plan year. The most important news in the IRS
guidance is the IRS’ interpretation of the term taxable year.
According to the IRS, because employees make salary reduction contribution elections for health
FSAs only on a plan-year basis, the term “taxable year” refers to the plan year of the cafeteria
plan. This means that:
The $2,500 limit on health FSA salary reduction contributions applies on a plan-year basis
It is effective for cafeteria plan years beginning after December 31, 2012
This clarification is good news for employers with non-calendar-year plans (or at least those
who did not already amend their plans to comply with a January 1, 2013 effective date). The
$2,500 limit will be indexed for cost-of-living adjustments for plan years beginning after
December 31, 2013.
APPLICABILITY
The $2,500 limit applies to employee pre-tax salary reduction contributions to a health FSA in a
cafeteria plan. The limit does not apply to employer non-elective credits (i.e., non-cashable flex
credits that an employer makes available to an employee who is eligible to participate in the
cafeteria plan, to be used (at the employee’s election) only for one or more qualified benefits.)
For example, if the employer contributes a $500 flex credit to each employee’s health FSA for the
2013 plan year, employees may still elect to make salary reduction contributions of $2,500 (as
indexed) to a health FSA for that plan year. If, however, employees can elect to receive the
employer-provided flex credit as cash or as a taxable benefit, then those flex credits are treated as
salary reduction contributions and are subject to the limit.
The limit does not apply to amounts available for reimbursement
under other employer-provided coverage, such as employee salary
reduction contributions to a dependent care spending account or
contributions used to pay an employee’s share of health coverage
premiums. The limit also does not apply to salary reduction or any
other contributions to a health savings account (HSA) or amounts
the employer makes available under a health reimbursement
arrangement (HRA).
POTENTIAL PENALTIES
A §125 cafeteria plan can only offer qualified benefits. A health FSA is
not considered a qualified benefit unless the cafeteria plan complies
with the $2,500 limit. A plan that offers a non-qualified benefit is not
a §125 cafeteria plan, so failure to implement the limit as required
will disqualify the employer’s cafeteria plan. When a cafeteria plan is
disqualified, the value of all taxable benefits that an employee could
have elected to receive under the plan during the plan year is
included in the employee’s gross income, regardless of the benefit
actually elected by the employee. In order for the health FSA to be
considered a qualified benefit, the cafeteria plan must be amended to
reflect the $2,500 limit and must comply also with the limit in
operation.
PLAN AMENDMENTS
The cafeteria plan must be amended to reflect the $2,500 limit.
Cafeteria plan rules generally provide that cafeteria plan
amendments must be adopted before they be put into operation.
Normally, therefore, implementing the $2,500 limit on a timely basis
would require amending the cafeteria plan before the beginning of
the first plan year starting after December 31, 2012. However, the
guidance provides that cafeteria plans may adopt the required
amendments to reflect the $2,500 limit with retroactive effect at any
time through the end of the calendar year 2014. The retroactive
amendment is only permitted if the plan is operated in accordance
with the limit starting with the first plan year beginning after
December 31, 2012, but it has until December 31, 2014 to adopt plan
amendments to reflect the limit.
MISTAKEN CONTRIBUTIONS
A cafeteria plan that fails to comply with the rules is not a §125
cafeteria plan, and the value of the taxable benefits that an employee
could have elected to receive under the plan during the plan year is
includible in the employee’s gross income. To avoid this result, the
cafeteria plan must comply with the $2,500 limit in operation. Even
under the best of circumstances, however, mistakes happen.
Fortunately, the guidance provides relief for certain salary reduction
contributions that exceed the $2,500 limit. The guidance provides
that if the cafeteria plan is amended to reflect the limit on a timely
basis, but employees are erroneously allowed to elect a salary
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reduction of more than $2,500 (as
indexed for inflation) for the plan year,
the cafeteria plan will continue to be a
§125 cafeteria plan if the following are
true:
The terms of the plan apply
uniformly to all participants
The error results from a reasonable
mistake by the employer (or its
agent)
Salary reduction contributions in
excess of the $2,500 limit (as
indexed) are paid to the employee
and reported as wages for income tax
withholding and employment tax
purposes on the employee’s Form W2 for the employee’s taxable year in
which, or with which, ends the
cafeteria plan year in which the
correction is made
Unfortunately, this relief is not available
for an employer whose federal tax return
is under examination (employer has
received written notification from
examining agents specifically citing
§125(i) as an issue under consideration)
with respect to benefits provided under a
cafeteria plan for any plan year during
which the failure to comply with the
requirements occurred.
EMPLOYEES AND
CONTROLLED GROUPS
The $2,500 limit applies on an employeeby-employee basis. The limit is the
maximum salary reduction contribution
each employee may make for a plan year,
regardless of the number of other
individuals (e.g., spouses or dependents)
whose medical expenses are
reimbursable under the employee’s
health FSA. This would allow each
spouse, if eligible to elect salary reduction
contributions to a health FSA, to elect to
make salary reduction contributions of
up to $2,500 (as indexed) to his or her
own health FSA (even if they both
participate in a health FSA sponsored by
the same employer).
Willis North America • 06/12
All employers that are treated as a single employer under §414(b), (c), or (m) relating to controlled groups and affiliated
service groups, are treated as a single employer for purposes of the $2,500 limit. If an employee participates in multiple
cafeteria plans offering health FSAs maintained by members of a controlled group or affiliated service group, the
employee’s total health FSA salary reduction contributions under all of the cafeteria plans are limited to $2,500 (as
indexed). If, however, an employee is employed by two or more employers that are not members of the same controlled
group, he or she may make salary reduction contributions up to $2,500 (as indexed) under each employer’s health FSA.
PLAN YEARS
The cafeteria plan rules allow a change in plan year if there is a valid business purpose. The guidance is clear that
changing the plan year to delay the application of the $2,500 limit is not a valid business purpose. Unless the change in
plan year is due to a valid business purpose, the plan year for the cafeteria plan remains the plan year that was in effect
prior to the attempted change.
The guidance further provides that if a cafeteria plan has a short plan year (e.g., less 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.
GRACE PERIODS
For plans providing a grace period (up to two months and 15 days immediately following the end of the plan year),
unused salary reduction contributions to the health FSA 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 $2,500 limit for the subsequent plan year.
CONCLUSION
Although the guidance brings welcome news for some non-calendar-year plans, it comes too late for many others.
Relying on a reasonable interpretation of “taxable year” as referring to the individual taxpayer’s tax year (which
generally is the calendar year), many plan sponsors who have health FSAs with plan years beginning in 2012 but ending
after January 1, 2013 have already amended their plans to comply with the $2,500 limit.
While plan sponsors have until December 31, 2013 to amend their plan documents to reflect the $2,500 limit, they will
need to ensure, as of the first plan year beginning on or after January 1, 2013, that employees may not elect salary
reduction contributions to the health FSA in excess of the $2,500 limit. Plan sponsors will want to review their current
processes to ensure that the plan will be administered in accordance with the requirements.
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Willis North America • 06/12
KEY CONTACTS
U.S. HUMAN CAPITAL PRACTICE OFFICE LOCATIONS
NEW ENGLAND
ATLANTIC
Auburn, ME
207 783 2211
Baltimore, MD
410 584 7528
Bangor, ME
207 942 4671
Knoxville, TN
865 588 8101
Boston, MA
617 437 6900
Memphis, TN
901 248 3103
Burlington, VT
802 264 9536
Metro DC
301 581 4262
Hartford, CT
860 756 7365
Nashville, TN
615 872 3716
Manchester, NH
603 627 9583
Norfolk, VA
757 628 2303
Portland, ME
207 553 2131
Reston, VA
703 435 7078
Shelton, CT
203 924 2994
Richmond, VA
804 527 2343
NORTHEAST
Rockville, MD
301 692 3025
Marietta, GA
770 425 6700
Miami, FL
305 421 6208
Mobile, AL
251 544 0212
Orlando, FL
407 562 2493
Raleigh, NC
704 344 4856
Savannah, GA
912 239 9047
Tallahassee, FL
850 385 3636
Tampa, FL
813 490 6808
813 289 7996
Vero Beach, FL
772 469 2842
MIDWEST
Buffalo, NY
716 856 1100
SOUTHEAST
Morristown, NJ
973 539 1923
Atlanta, GA
404 224 5000
Mt. Laurel, NJ
856 914 4600
Birmingham, AL
205 871 3300
Chicago, IL
312 288 7700
312 348 7700
New York, NY
212 915 8802
Charlotte, NC
704 344 4856
Cleveland, OH
216 861 9100
Norwalk, CT
203 523 0501
Gainesville, FL
352 378 2511
Columbus, OH
614 326 4722
Radnor, PA
610 254 7289
Greenville, SC
704 344 4856
Detroit, MI
248 539 6600
Wilmington, DE
302 397 0171
Jacksonville, FL
904 355 4600
Grand Rapids, MI
616 957 2020
Appleton, WI
800 236 3311
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Willis North America • 06/12
Milwaukee, WI
414 203 5248
414 259 8837
Wichita, KS
316 263 3211
WESTERN
Minneapolis, MN
763 302 7131
763 302 7209
Fresno, CA
559 256 6212
Moline, IL
309 764 9666
Irvine, CA
949 885 1200
Pittsburgh, PA
412 645 8506
Las Vegas, NV
602 787 6235
602 787 6078
Schaumburg, IL
847 517 3469
Los Angeles, CA
213 607 6300
SOUTH CENTRAL
Amarillo, TX
806 376 4761
Austin, TX
512 651 1660
Dallas, TX
972 715 2194
972 715 6272
Denver, CO
303 765 1564
303 773 1373
Houston, TX
713 625 1017
713 625 1082
McAllen, TX
956 682 9423
Mills, WY
307 266 6568
Novato, CA
415 493 5210
Phoenix, AZ
602 787 6235
602 787 6078
Portland, OR
503 274 6224
Rancho/Irvine, CA
562 435 2259
San Diego, CA
858 678 2000
858 678 2132
San Francisco, CA
415 291 1567
San Jose, CA
408 436 7000
Seattle, WA
800 456 1415
New Orleans, LA
504 581 6151
Oklahoma City, OK
405 232 0651
Overland Park, KS
913 339 0800
The information contained in this publication is
not intended to represent legal or tax advice and
has been prepared solely for educational
purposes. You may wish to consult your attorney or tax adviser regarding issues raised in this
publication.
San Antonio, TX
210 979 7470
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Willis North America • 06/12