IRS Guidance Addresses Effective Date of $2,500 Limit on Salary Reduction Contributions to Health FSAs | Practical Law

IRS Guidance Addresses Effective Date of $2,500 Limit on Salary Reduction Contributions to Health FSAs | Practical Law

In Notice 2012-40, the Internal Revenue Service (IRS) announced that the $2,500 limit on salary reduction contributions to health flexible spending arrangements (health FSAs) required under the Affordable Care Act (ACA) is effective for cafeteria plan years beginning after December 31, 2012. Cafeteria plans that do not comply with the $2,500 limit for plan years beginning after December 31, 2012 will not be considered cafeteria plans under Section 125 of the Internal Revenue Code (IRC).  

IRS Guidance Addresses Effective Date of $2,500 Limit on Salary Reduction Contributions to Health FSAs

by PLC Employee Benefits & Executive Compensation
Published on 01 Jun 2012 • USA (National/Federal)
In Notice 2012-40, the Internal Revenue Service (IRS) announced that the $2,500 limit on salary reduction contributions to health flexible spending arrangements (health FSAs) required under the Affordable Care Act (ACA) is effective for cafeteria plan years beginning after December 31, 2012. Cafeteria plans that do not comply with the $2,500 limit for plan years beginning after December 31, 2012 will not be considered cafeteria plans under Section 125 of the Internal Revenue Code (IRC).
On May 30, 2012, the IRS issued Notice 2012-40, which provides guidance on the Affordable Care Act's (ACA's) $2,500 limit on salary reduction contributions for health flexible spending arrangements (health FSAs) offered under cafeteria plans (for more information on cafeteria plans, see Practice Note, Cafeteria Plans). In Notice 2012-40, the IRS clarified that the term "taxable year" for purposes of the $2,500 limit is the plan year of the cafeteria plan (because that is the period for which salary reductions are made), so that the $2,500 limit:
  • Applies on a plan year basis.
  • Is effective for plan years beginning after December 31, 2012.
A cafeteria plan that does not timely comply with the $2,500 limit is not an IRC Section 125 cafeteria plan, and the value of taxable benefits an employee could have elected to receive under the plan is includible in the employee's gross income.
Notice 2012-40 provides that the $2,500 limit will be prorated for short plan years (less than 12 months). Also, for plan years that begin after December 31, 2013, the $2,500 limit will be indexed for cost-of-living adjustments. For cafeteria plans that allow employees to spend unused contributions during a grace period, the contributions that are carried over into the grace period do not count against the $2,500 limit for the following plan year.

Limit Applies on Employee-by-Employee Basis

According to Notice 2012-40, the $2,500 limit applies to each employee, regardless of the number of individuals (for example, spouses, dependents or adult children) whose medical expenses are reimbursable under the employee's health FSA. Therefore, if two spouses are eligible to make salary reduction contributions to a health FSA sponsored by the same employer, each spouse may contribute up to $2,500 (indexed for inflation after 2013).

Applicability of $2,500 Limit

The $2,500 limit:
  • Applies only to salary reduction contributions under a health FSA.
  • Does not apply to:
    • certain employer non-elective contributions (flex credits);
    • contributions or amounts available for reimbursement under other types of FSAs, HSAs or HRAs; and
    • salary reductions to cafeteria plans used to pay either an employee's share of health coverage premiums or the corresponding employee share under a self-insured plan.

Written Cafeteria Plan Amendments

Cafeteria plans that offer a health FSA must be amended to reflect the $2,500 limit. Although proposed regulations addressing cafeteria plans include a rule against retroactive cafeteria plan amendments, Notice 2012-40 permits cafeteria plans to be amended retroactively to comply with the $2,500 limit if:
  • The amendment is adopted on or before December 31, 2014.
  • The plan is operated consistent with the $2,500 limit, including the guidance under Notice 2012-40, for plan years beginning after December 31, 2012.

Correction Procedure for Excess Salary Reduction Contributions

Notice 2012-40 includes a correction procedure that applies:
  • If a cafeteria plan has timely satisfied the written plan requirement.
  • When one or more employees nonetheless are permitted, in error, to elect salary reduction contributions exceeding the $2,500 limit for a plan year.
In this case, the cafeteria plan will continue to be an IRC Section 125 cafeteria plan for a plan year if:
  • The plan terms apply uniformly to all participants.
  • The error is due to a reasonable mistake by the employer (or the employer's agent) and not because of willful neglect.
  • The contributions that exceed $2,500 (or the inflation-indexed amount) are:
    • paid to the employee; and
    • reported as wages for income tax withholding and employment tax purposes on the employee's IRS Form W-2 or Form W-2c.
However, this relief for mistaken excess contributions does not apply where an employer's federal tax return is under investigation regarding benefits provided for a plan year during which a failure to satisfy the $2,500 limit occurred.

Request for Comment on Possible Use-or-lose Modifications

Notice 2012-40 announces that, in light of the $2,500 limit, the IRS is requesting comments regarding:
  • Whether the proposed cafeteria plan regulations should be modified to offer greater flexibility as to how the use-or-lose rule operates for health FSAs.
  • How this additional flexibility, if any, might be provided.

Practical Implications

Plan sponsors, particularly those with non-calendar year plans, will welcome certain of the clarifications in Notice 2012-40. Helpful aspects of this guidance include the additional time for making conforming cafeteria plan amendments to reflect the $2,500 limit and the correction procedure for employees who are mistakenly allowed to elect salary reductions of more than $2,500. However, a caveat should be noted regarding the clarification that "taxable year" refers to the plan year of a cafeteria plan. Specifically, if an employer's principal purpose in changing from a calendar year to a fiscal year is to delay application of the $2,500 limit, the change will not satisfy the "valid business purpose" requirement under the proposed cafeteria plan regulations. As a result, the plan year will remain the plan year that was in effect before the attempted change.