The Internal Revenue Service has come up with procedures for employers that want to help employees shift unused flexible spending account assets into health savings accounts.

The procedures, spelled out in IRS Notice 2007-22, implement Section 302 of the Health Opportunity Patient Empowerment Act of 2006, which creates an unusual opportunity for FSA holders to do something other than lose unused account funds at the end of the year.

The law permits some FSA holders to transfer unused FSA assets into HSAs one time before Jan. 1, 2012.

The same law also permits holders of health reimbursement arrangements to transfer HRA assets into HSAs by 2012.

FSA and HRA rules give taxpayers great flexibility in spending account funds on qualified health care expenses. HSA rules, in contrast, require taxpayers to own HSA-compatible high-deductible health coverage.

FSA holders might like the idea of putting FSA assets into HSAs simply to avoid losing assets to the notorious FSA “use it or lose it” rule, officials say.

HRA holders do not face a use-it-or-lose-it rule, but they may want to convert HRA assets into HSA assets because HSA assets are portable and HRA assets are not. In addition, HSA holders can invest HSA assets in a wide array of investments. HRA holders cannot earn interest or dividends on HRA assets, according to program rules.

IRS officials write in the new notice that employers and employees must normally meet the following conditions to receive favorable tax treatment:

1. By the end of the plan year:

- The plan must be amended.

- The employee must elect the rollover.

- The year-end balance must be frozen.

2. The funds must be transferred by the employer within 2.5 months after of the end of the plan year and result in a 0 balance in the health FSA or HRA.

Under special transition relief for amounts remaining in health FSAs and HRAs at the end of 2006:

1. There is no requirement to freeze the year-end balance.

2. The amendment, election and transfer must take place by March 15.

In addition, a health FSA involved in any transfers must have a grace period provision, IRS officials write in the guidance. Otherwise, any unused amounts in the FSA must be forfeited at the end of the plan year, officials write.

Other provisions of the new FSA and HRA rollover guidance note that:

- Transfers from FSAs and HRAs into HSAs are not deductible, and they do not count toward the HSA deduction limit.

- A taxpayer who uses an FSA or HRA rollover, then violates the HSA program rules by, for example, not having HSA-compatible health coverage, must add the rollover amount to taxable income along with an additional 10% tax.

“For all purposes, balances are determined on a cash basis,” officials write. “Cash basis means the balance as of any date, without taking into account expenses incurred that have not been reimbursed as of that date. Thus, pending claims, claims submitted, claims received or claims under review that have not been paid as of a date are not taken into account for purposes of determining the account balances as of that date.”

The new guidance also includes 13 examples showing how IRS officials want employers and employees to apply the new procedures.

A copy of the IRS notice is on the Web at Document Link