IRS Guidance on $2,500 Health FSA Cap Update for 2013; IRS & Legislation May Change Use It Or Lose It Rule

IRS Notice 2012-40 deals with the $2500 cap imposed by health care reform under § 125(i) of the Internal Revenue Code on employee salary deferrals to a health FSA in 2013 and thereafter. The $2,500 Health FSA limit does not apply to premium conversion Premium Only Plans (POP) and other various options in a cafeteria plan, such as dependent care and adoption assistance. IRS Notice 2012-40 provides:

• The $2,500 limit applies only to salary reduction contributions under a health FSA, and does not apply to certain employer non-elective contributions (flex credits) or to any types of contributions or amounts available for reimbursement under other types of FSAs, health savings accounts, or reimbursement arrangements, including salary reduction contributions used to pay an employee’s share of health coverage (insured or self-insured) dependent care, and/or adoption assistance.
• The cap applies to Health FSA plans that begin on or after January 1, 2013. Thus, the new cap will not apply to non-calendar year plans until the plan year beginning in 2013. However, a plan sponsor cannot change from a calendar year to a non-calendar plan year to postpone the new cap absent a bona fide business reason for the change.
• For plans that have adopted the optional cafeteria plan 2-1/2  month grace period[1], amounts carried over during the grace period do not count toward the cap.
• The employer can correct employee deferral contributions that exceed the limit if due to a reasonable mistake and not willful misconduct if the cafeteria plan is not under IRS audit. The employer pays the excess amount to the employee, which is reported as wages for income tax withholding and employment taxes on the employee’s Form W-2 for the employee’s taxable year that ends with or after the cafeteria plan year in which the correction is made.
• The relief provided in this section III with respect to erroneous excess contributions is not available for an employer if a federal tax return of the employer is under examination with respect to benefits provided under a cafeteria plan.
• Employers have until the end of 2014 to amend their plan documents to incorporate the $2500 limit, but this change must be effective for the plan year beginning in 2013.[2]
• If both spouses have an FSA, whether at the same or different employers, each can fund his/her health FSA to the full amount of the $2500 limit.
• An individual employed by separate employers that are not members of the same controlled group or affiliated service group may establish and fund an FSA at each employer up to the $2500 limit.
• A cafeteria plan that fails to comply with § 125(i) for plan years beginning in 2013 is not a valid § 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 employee’s gross income, regardless of the benefit elected by the employee.[3]
• If a cafeteria plan has a short plan year (fewer than 12 months) that begins after 2012, the $2,500 limit is prorated based on the number of months in that short plan year.

Notice 2012-40 also states  that the IRS  is considering modifying the “use it or lose it” rule to provide relief to employees. The IRS has invited comments on this issue. Additionally, the Medical FSA Improvement Act of 2011, H.R. 1004, passed the House Ways and Means Committee by a 23-6 vote.  If this bill becomes law, employers could amend their FSAs to allow employees to withdraw as taxable cash up to $500 in unused balances remaining at the end of the plan year or at the end of an FSA grace period, if later.