On October 31, 2013, the IRS, in Notice 2013-71 (Notice), announced a significant change to the "use-or-lose" rule for health flexible spending arrangements (health FSAs) offered under cafeteria plans. Under the change, cafeteria plans can be amended to allow up to $500 of unused health FSA amounts remaining at the end of a plan year to be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year.

The Notice also clarifies the scope of transition relief previously provided in the preamble to proposed regulations addressing Section 4980H of the Internal Revenue Code (IRC) (that is, the Affordable Care Act's (ACA's) employer mandate rules) (see Practice Notes, Employer Mandate under the ACA: Overview and Employer Mandate under the ACA: Determining Full-time Employees for Employer Penalties). This prior guidance permitted participants greater flexibility to change their cafeteria plan salary reduction elections for non-calendar cafeteria plan years beginning in 2013 (see Legal Update, IRS Proposed Rules on Employer Mandate Include Transition Relief for Cafeteria Plan Elections).

Cafeteria plans are subject to a "use-or-lose" rule under which unused benefits or contributions remaining at the end of the plan year are forfeited. However, plans may include a grace period under which employees can use amounts remaining from the previous year to pay expenses for certain benefits for up to two months and 15 days immediately following the end of a plan year. In earlier guidance, the IRS requested comments regarding whether the use-or-lose rule should be changed to add greater flexibility. According to the IRS, the "overwhelming majority" of comments received favored changes to the rule.

Under the Notice, employers can amend their cafeteria plans to permit the carryover to the immediately following plan year of up to $500 of unused amounts remaining at the end of a health FSA's plan year (that is, after medical expenses have been reimbursed at the end of the plan's run-out period). The carryover:

Plans can choose a carryover amount of less than $500 (or not permit a carryover at all), but the same carryover limit must apply to all participants. The Notice describes other restrictions on how carryover amounts must be handled (for example, amounts cannot be cashed out or converted to other taxable or nontaxable benefits).

The uniform coverage rule under the cafeteria plan regulations also applies to carryovers. Under this rule, the maximum amount of reimbursement from the health FSA (including salary reductions and nonelective employer flex credits) generally must be available for claims incurred at all times during the coverage period. Also, a health FSA that adopts a carryover can still permit the payment of expenses incurred in one plan year during a run-out period at the beginning of the following plan year.

In prior guidance, the IRS provided transition relief to address the fact that the cafeteria plan rules did not allow employees to:

The transition relief allowed for a cafeteria plan amendment to allow employees to make either or both of the following changes to their salary reduction elections, regardless of whether they experienced a change in status event:

In the Notice, the IRS clarifies that although the description of the transition relief referred to applicable large employer members, it is generally available to an employer with a non-calendar plan year cafeteria plan beginning in 2013 whether or not the employer is an applicable large employer (or applicable large employer member) under IRC Section 4980H.

A cafeteria plan amendment adopted under the transition relief may:

For example, an employer could amend its cafeteria plan to allow an employee who elected to salary reduce through the cafeteria plan to pay for health coverage under the plan (with a non-calendar plan year beginning in 2013) to prospectively revoke or change the election once, during a limited period (for example, the first month of 2014 only rather than the entire plan year) regardless of whether the employee experienced a change in status event under the cafeteria plan rules.

Although the IRS' decision to loosen the use-or-lose rule will be welcome news to many (including those commenters who argued for greater administrative flexibility), plan sponsors wishing to adopt a carryover should note that the new option comes with significant strings attached. From a plan design perspective, for example, plans using a grace period will need to weigh that feature against adding a carryover (since they cannot have both). Fortunately, the Notice includes an extended deadline for plan amendments formally adopting a carryover for 2013 plan years (subject to certain requirements, discussed above). Also, among other administrative issues, plans will need to consider whether current-year expenses will be reimbursed first from unused amounts credited for the current year or from carryover amounts.