The Internal Revenue Service says some employers may face a collision between health savings account rules and flexible spending arrangement rules in early 2006.[@@]

Shoshanna Tanner, an IRS tax-exempt entities official, describes the conflict and offers transition relief in IRS Notice 2005-86.

The IRS recently issued a notice that lets sponsors of FSA plans bend the notorious, much-hated “use it or lose it” rule for FSA assets, by creating a “grace period.”

In practice, the new grace period rule lets an employer with an FSA year that started Jan. 1 give plan members until March 15, 2006, to spend all 2005 FSA contributions.

Meanwhile, Tanner writes, many employers also want to offer health savings account programs starting Jan. 1, 2006.

Holders of HSAs must have special high-deductible health insurance plans. They can have “limited purpose FSAs” that cover only expenses for preventive care, dental care or vision care. HSA holders also can have “post-deductible health FSAs” that start covering eligible medical expenses only after the HSA holders have met their annual health insurance deductibles, Tanner writes.

Under the current rules, employees who now have general purpose health FSAs, with a grace period running from Jan. 1, 2006, to March 15, 2006, will not be eligible to contribute to HSAs until April 1, 2006, Tanner writes.

In that case, the employees would be able to contribute only 75% of the 2006 HSA contribution limit, Tanner writes.

Employers can get around the conflict by converting the general purpose health FSA to an HSA-compatible FSA during the grace period for all participants, Tanner writes.

Tanner does not address the compliance implications of taking away FSA holders’ ability to use FSA funds for general health expenses during the grace period.

Tanner does offer some transition relief.

For cafeteria plans with plan years ending before June 5 and grace periods ending before Sept. 1, an employer can let members of general purpose FSAs contribute to HSAs if the employees have used up their FSA contributions or the employer changes the “cafeteria plan document to provide that the grace period does not provide coverage to an individual who elects [high-deductible health plan] coverage,” Tanner writes.

A copy of the notice is on the Web at http://www.treasury.gov/press/releases/reports/n0586.pdf