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HUMAN CAPITAL PRACTICE
ALERT:
HEALTH CARE REFORM BILL
June 2012                                                    www.willis.com



GUIDANCE ISSUED ON
$2,500 HEALTH FSA LIMIT
The Internal Revenue Service (IRS) has issued guidance regarding the $2,500 limit on
employees’ pre-tax contributions to health flexible spending accounts (FSA). The limit was
enacted in 2010 as part of the federal health care reform law, and Notice 2012-40 provides
guidance employers need for implementing it, including the effective date, the time limit for
amending plans, and what happens if too much is mistakenly contributed.


EFFECTIVE DATE
Under §125(i) of the Internal Revenue Code (IRC), “an employee may not elect for any taxable
year to have salary reduction contributions in excess of $2,500 made to” a health FSA. The
effective date stated in the health care reform law was any tax year beginning after 2012, and it
seemed clear that this referred to the employee’s tax year (i.e., the calendar year). As a result,
experts concluded that the statute required implementing the limit on a calendar-year basis for
all plans starting January 1, 2013, regardless of the plan year. The most important news in the IRS
guidance is the IRS’ interpretation of the term taxable year.

According to the IRS, because employees make salary reduction contribution elections for health
FSAs only on a plan-year basis, the term “taxable year” refers to the plan year of the cafeteria
plan. This means that:

    The $2,500 limit on health FSA salary reduction contributions applies on a plan-year basis
    It is effective for cafeteria plan years beginning after December 31, 2012

This clarification is good news for employers with non-calendar-year plans (or at least those
who did not already amend their plans to comply with a January 1, 2013 effective date). The
$2,500 limit will be indexed for cost-of-living adjustments for plan years beginning after
December 31, 2013.


APPLICABILITY
The $2,500 limit applies to employee pre-tax salary reduction contributions to a health FSA in a
cafeteria plan. The limit does not apply to employer non-elective credits (i.e., non-cashable flex
credits that an employer makes available to an employee who is eligible to participate in the
cafeteria plan, to be used (at the employee’s election) only for one or more qualified benefits.)
For example, if the employer contributes a $500 flex credit to each employee’s health FSA for the
2013 plan year, employees may still elect to make salary reduction contributions of $2,500 (as
indexed) to a health FSA for that plan year. If, however, employees can elect to receive the
employer-provided flex credit as cash or as a taxable benefit, then those flex credits are treated as
salary reduction contributions and are subject to the limit.
The limit does not apply to amounts available for reimbursement           reduction of more than $2,500 (as
under other employer-provided coverage, such as employee salary           indexed for inflation) for the plan year,
reduction contributions to a dependent care spending account or           the cafeteria plan will continue to be a
contributions used to pay an employee’s share of health coverage          §125 cafeteria plan if the following are
premiums. The limit also does not apply to salary reduction or any        true:
other contributions to a health savings account (HSA) or amounts
the employer makes available under a health reimbursement                     The terms of the plan apply
arrangement (HRA).                                                            uniformly to all participants
                                                                              The error results from a reasonable
POTENTIAL PENALTIES                                                           mistake by the employer (or its
                                                                              agent)
A §125 cafeteria plan can only offer qualified benefits. A health FSA is         Salary reduction contributions in
not considered a qualified benefit unless the cafeteria plan complies           excess of the $2,500 limit (as
with the $2,500 limit. A plan that offers a non-qualified benefit is not         indexed) are paid to the employee
a §125 cafeteria plan, so failure to implement the limit as required          and reported as wages for income tax
will disqualify the employer’s cafeteria plan. When a cafeteria plan is       withholding and employment tax
disqualified, the value of all taxable benefits that an employee could          purposes on the employee’s Form W-
have elected to receive under the plan during the plan year is                2 for the employee’s taxable year in
included in the employee’s gross income, regardless of the benefit             which, or with which, ends the
actually elected by the employee. In order for the health FSA to be           cafeteria plan year in which the
considered a qualified benefit, the cafeteria plan must be amended to           correction is made
reflect the $2,500 limit and must comply also with the limit in
operation.                                                                Unfortunately, this relief is not available
                                                                          for an employer whose federal tax return
                                                                          is under examination (employer has
PLAN AMENDMENTS                                                           received written notification from
                                                                          examining agents specifically citing
The cafeteria plan must be amended to reflect the $2,500 limit.
                                                                          §125(i) as an issue under consideration)
Cafeteria plan rules generally provide that cafeteria plan
                                                                          with respect to benefits provided under a
amendments must be adopted before they be put into operation.
                                                                          cafeteria plan for any plan year during
Normally, therefore, implementing the $2,500 limit on a timely basis
                                                                          which the failure to comply with the
would require amending the cafeteria plan before the beginning of
                                                                          requirements occurred.
the first plan year starting after December 31, 2012. However, the
guidance provides that cafeteria plans may adopt the required
amendments to reflect the $2,500 limit with retroactive effect at any       EMPLOYEES AND
time through the end of the calendar year 2014. The retroactive           CONTROLLED GROUPS
amendment is only permitted if the plan is operated in accordance
with the limit starting with the first plan year beginning after           The $2,500 limit applies on an employee-
December 31, 2012, but it has until December 31, 2014 to adopt plan       by-employee basis. The limit is the
amendments to reflect the limit.                                           maximum salary reduction contribution
                                                                          each employee may make for a plan year,
MISTAKEN CONTRIBUTIONS                                                    regardless of the number of other
                                                                          individuals (e.g., spouses or dependents)
A cafeteria plan that fails to comply with the rules is not a §125        whose medical expenses are
cafeteria plan, and the value of the taxable benefits that an employee     reimbursable under the employee’s
could have elected to receive under the plan during the plan year is      health FSA. This would allow each
includible in the employee’s gross income. To avoid this result, the      spouse, if eligible to elect salary reduction
cafeteria plan must comply with the $2,500 limit in operation. Even       contributions to a health FSA, to elect to
under the best of circumstances, however, mistakes happen.                make salary reduction contributions of
                                                                          up to $2,500 (as indexed) to his or her
Fortunately, the guidance provides relief for certain salary reduction    own health FSA (even if they both
contributions that exceed the $2,500 limit. The guidance provides         participate in a health FSA sponsored by
that if the cafeteria plan is amended to reflect the limit on a timely     the same employer).
basis, but employees are erroneously allowed to elect a salary

                                                             2                              Willis North America • 06/12
All employers that are treated as a single employer under §414(b), (c), or (m) relating to controlled groups and affiliated
service groups, are treated as a single employer for purposes of the $2,500 limit. If an employee participates in multiple
cafeteria plans offering health FSAs maintained by members of a controlled group or affiliated service group, the
employee’s total health FSA salary reduction contributions under all of the cafeteria plans are limited to $2,500 (as
indexed). If, however, an employee is employed by two or more employers that are not members of the same controlled
group, he or she may make salary reduction contributions up to $2,500 (as indexed) under each employer’s health FSA.

PLAN YEARS
The cafeteria plan rules allow a change in plan year if there is a valid business purpose. The guidance is clear that
changing the plan year to delay the application of the $2,500 limit is not a valid business purpose. Unless the change in
plan year is due to a valid business purpose, the plan year for the cafeteria plan remains the plan year that was in effect
prior to the attempted change.

The guidance further provides that if a cafeteria plan has a short plan year (e.g., less than 12 months) that begins after
2012, the $2,500 limit must be prorated based on the number of months in that short plan year.


GRACE PERIODS
For plans providing a grace period (up to two months and 15 days immediately following the end of the plan year),
unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over
into the grace period for that plan year will not count against the $2,500 limit for the subsequent plan year.


CONCLUSION
Although the guidance brings welcome news for some non-calendar-year plans, it comes too late for many others.
Relying on a reasonable interpretation of “taxable year” as referring to the individual taxpayer’s tax year (which
generally is the calendar year), many plan sponsors who have health FSAs with plan years beginning in 2012 but ending
after January 1, 2013 have already amended their plans to comply with the $2,500 limit.

While plan sponsors have until December 31, 2013 to amend their plan documents to reflect the $2,500 limit, they will
need to ensure, as of the first plan year beginning on or after January 1, 2013, that employees may not elect salary
reduction contributions to the health FSA in excess of the $2,500 limit. Plan sponsors will want to review their current
processes to ensure that the plan will be administered in accordance with the requirements.




                                                                   3                               Willis North America • 06/12
KEY CONTACTS
U.S. HUMAN CAPITAL PRACTICE OFFICE LOCATIONS


NEW ENGLAND            ATLANTIC                Marietta, GA
                                               770 425 6700
Auburn, ME             Baltimore, MD
207 783 2211           410 584 7528            Miami, FL
                                               305 421 6208
Bangor, ME             Knoxville, TN
207 942 4671           865 588 8101            Mobile, AL
                                               251 544 0212
Boston, MA             Memphis, TN
617 437 6900           901 248 3103            Orlando, FL
                                               407 562 2493
Burlington, VT         Metro DC
802 264 9536           301 581 4262            Raleigh, NC
                                               704 344 4856
Hartford, CT           Nashville, TN
860 756 7365           615 872 3716            Savannah, GA
                                               912 239 9047
Manchester, NH         Norfolk, VA
603 627 9583           757 628 2303            Tallahassee, FL
                                               850 385 3636
Portland, ME           Reston, VA
207 553 2131           703 435 7078            Tampa, FL
                                               813 490 6808
Shelton, CT            Richmond, VA            813 289 7996
203 924 2994           804 527 2343
                                               Vero Beach, FL
NORTHEAST              Rockville, MD           772 469 2842
                       301 692 3025
Buffalo, NY                                    MIDWEST
716 856 1100           SOUTHEAST
                                               Appleton, WI
Morristown, NJ         Atlanta, GA             800 236 3311
973 539 1923           404 224 5000
                                               Chicago, IL
Mt. Laurel, NJ         Birmingham, AL          312 288 7700
856 914 4600           205 871 3300            312 348 7700

New York, NY           Charlotte, NC           Cleveland, OH
212 915 8802           704 344 4856            216 861 9100

Norwalk, CT            Gainesville, FL         Columbus, OH
203 523 0501           352 378 2511            614 326 4722

Radnor, PA             Greenville, SC          Detroit, MI
610 254 7289           704 344 4856            248 539 6600

Wilmington, DE         Jacksonville, FL        Grand Rapids, MI
302 397 0171           904 355 4600            616 957 2020




                                         4                    Willis North America • 06/12
Milwaukee, WI       Wichita, KS
414 203 5248        316 263 3211
414 259 8837
                    WESTERN
Minneapolis, MN
763 302 7131        Fresno, CA
763 302 7209        559 256 6212

Moline, IL          Irvine, CA
309 764 9666        949 885 1200

Pittsburgh, PA      Las Vegas, NV
412 645 8506        602 787 6235
                    602 787 6078
Schaumburg, IL
847 517 3469        Los Angeles, CA
                    213 607 6300
SOUTH CENTRAL
                    Novato, CA
Amarillo, TX        415 493 5210
806 376 4761
                    Phoenix, AZ
Austin, TX          602 787 6235
512 651 1660        602 787 6078

Dallas, TX          Portland, OR
972 715 2194        503 274 6224
972 715 6272
                    Rancho/Irvine, CA
Denver, CO          562 435 2259
303 765 1564
303 773 1373        San Diego, CA
                    858 678 2000
Houston, TX         858 678 2132
713 625 1017
713 625 1082        San Francisco, CA
                    415 291 1567
McAllen, TX
956 682 9423        San Jose, CA
                    408 436 7000
Mills, WY
307 266 6568        Seattle, WA
                    800 456 1415
New Orleans, LA
504 581 6151
                    The information contained in this publication is
                    not intended to represent legal or tax advice and
Oklahoma City, OK
                    has been prepared solely for educational
405 232 0651        purposes. You may wish to consult your attor-
                    ney or tax adviser regarding issues raised in this
Overland Park, KS   publication.
913 339 0800

San Antonio, TX
210 979 7470




                                                5                        Willis North America • 06/12

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HCR Alert jun_2012_guidance_fsa_limit

  • 1. HUMAN CAPITAL PRACTICE ALERT: HEALTH CARE REFORM BILL June 2012 www.willis.com GUIDANCE ISSUED ON $2,500 HEALTH FSA LIMIT The Internal Revenue Service (IRS) has issued guidance regarding the $2,500 limit on employees’ pre-tax contributions to health flexible spending accounts (FSA). The limit was enacted in 2010 as part of the federal health care reform law, and Notice 2012-40 provides guidance employers need for implementing it, including the effective date, the time limit for amending plans, and what happens if too much is mistakenly contributed. EFFECTIVE DATE Under §125(i) of the Internal Revenue Code (IRC), “an employee may not elect for any taxable year to have salary reduction contributions in excess of $2,500 made to” a health FSA. The effective date stated in the health care reform law was any tax year beginning after 2012, and it seemed clear that this referred to the employee’s tax year (i.e., the calendar year). As a result, experts concluded that the statute required implementing the limit on a calendar-year basis for all plans starting January 1, 2013, regardless of the plan year. The most important news in the IRS guidance is the IRS’ interpretation of the term taxable year. According to the IRS, because employees make salary reduction contribution elections for health FSAs only on a plan-year basis, the term “taxable year” refers to the plan year of the cafeteria plan. This means that: The $2,500 limit on health FSA salary reduction contributions applies on a plan-year basis It is effective for cafeteria plan years beginning after December 31, 2012 This clarification is good news for employers with non-calendar-year plans (or at least those who did not already amend their plans to comply with a January 1, 2013 effective date). The $2,500 limit will be indexed for cost-of-living adjustments for plan years beginning after December 31, 2013. APPLICABILITY The $2,500 limit applies to employee pre-tax salary reduction contributions to a health FSA in a cafeteria plan. The limit does not apply to employer non-elective credits (i.e., non-cashable flex credits that an employer makes available to an employee who is eligible to participate in the cafeteria plan, to be used (at the employee’s election) only for one or more qualified benefits.) For example, if the employer contributes a $500 flex credit to each employee’s health FSA for the 2013 plan year, employees may still elect to make salary reduction contributions of $2,500 (as indexed) to a health FSA for that plan year. If, however, employees can elect to receive the employer-provided flex credit as cash or as a taxable benefit, then those flex credits are treated as salary reduction contributions and are subject to the limit.
  • 2. The limit does not apply to amounts available for reimbursement reduction of more than $2,500 (as under other employer-provided coverage, such as employee salary indexed for inflation) for the plan year, reduction contributions to a dependent care spending account or the cafeteria plan will continue to be a contributions used to pay an employee’s share of health coverage §125 cafeteria plan if the following are premiums. The limit also does not apply to salary reduction or any true: other contributions to a health savings account (HSA) or amounts the employer makes available under a health reimbursement The terms of the plan apply arrangement (HRA). uniformly to all participants The error results from a reasonable POTENTIAL PENALTIES mistake by the employer (or its agent) A §125 cafeteria plan can only offer qualified benefits. A health FSA is Salary reduction contributions in not considered a qualified benefit unless the cafeteria plan complies excess of the $2,500 limit (as with the $2,500 limit. A plan that offers a non-qualified benefit is not indexed) are paid to the employee a §125 cafeteria plan, so failure to implement the limit as required and reported as wages for income tax will disqualify the employer’s cafeteria plan. When a cafeteria plan is withholding and employment tax disqualified, the value of all taxable benefits that an employee could purposes on the employee’s Form W- have elected to receive under the plan during the plan year is 2 for the employee’s taxable year in included in the employee’s gross income, regardless of the benefit which, or with which, ends the actually elected by the employee. In order for the health FSA to be cafeteria plan year in which the considered a qualified benefit, the cafeteria plan must be amended to correction is made reflect the $2,500 limit and must comply also with the limit in operation. Unfortunately, this relief is not available for an employer whose federal tax return is under examination (employer has PLAN AMENDMENTS received written notification from examining agents specifically citing The cafeteria plan must be amended to reflect the $2,500 limit. §125(i) as an issue under consideration) Cafeteria plan rules generally provide that cafeteria plan with respect to benefits provided under a amendments must be adopted before they be put into operation. cafeteria plan for any plan year during Normally, therefore, implementing the $2,500 limit on a timely basis which the failure to comply with the would require amending the cafeteria plan before the beginning of requirements occurred. the first plan year starting after December 31, 2012. However, the guidance provides that cafeteria plans may adopt the required amendments to reflect the $2,500 limit with retroactive effect at any EMPLOYEES AND time through the end of the calendar year 2014. The retroactive CONTROLLED GROUPS amendment is only permitted if the plan is operated in accordance with the limit starting with the first plan year beginning after The $2,500 limit applies on an employee- December 31, 2012, but it has until December 31, 2014 to adopt plan by-employee basis. The limit is the amendments to reflect the limit. maximum salary reduction contribution each employee may make for a plan year, MISTAKEN CONTRIBUTIONS regardless of the number of other individuals (e.g., spouses or dependents) A cafeteria plan that fails to comply with the rules is not a §125 whose medical expenses are cafeteria plan, and the value of the taxable benefits that an employee reimbursable under the employee’s could have elected to receive under the plan during the plan year is health FSA. This would allow each includible in the employee’s gross income. To avoid this result, the spouse, if eligible to elect salary reduction cafeteria plan must comply with the $2,500 limit in operation. Even contributions to a health FSA, to elect to under the best of circumstances, however, mistakes happen. make salary reduction contributions of up to $2,500 (as indexed) to his or her Fortunately, the guidance provides relief for certain salary reduction own health FSA (even if they both contributions that exceed the $2,500 limit. The guidance provides participate in a health FSA sponsored by that if the cafeteria plan is amended to reflect the limit on a timely the same employer). basis, but employees are erroneously allowed to elect a salary 2 Willis North America • 06/12
  • 3. All employers that are treated as a single employer under §414(b), (c), or (m) relating to controlled groups and affiliated service groups, are treated as a single employer for purposes of the $2,500 limit. If an employee participates in multiple cafeteria plans offering health FSAs maintained by members of a controlled group or affiliated service group, the employee’s total health FSA salary reduction contributions under all of the cafeteria plans are limited to $2,500 (as indexed). If, however, an employee is employed by two or more employers that are not members of the same controlled group, he or she may make salary reduction contributions up to $2,500 (as indexed) under each employer’s health FSA. PLAN YEARS The cafeteria plan rules allow a change in plan year if there is a valid business purpose. The guidance is clear that changing the plan year to delay the application of the $2,500 limit is not a valid business purpose. Unless the change in plan year is due to a valid business purpose, the plan year for the cafeteria plan remains the plan year that was in effect prior to the attempted change. The guidance further provides that if a cafeteria plan has a short plan year (e.g., less than 12 months) that begins after 2012, the $2,500 limit must be prorated based on the number of months in that short plan year. GRACE PERIODS For plans providing a grace period (up to two months and 15 days immediately following the end of the plan year), unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the $2,500 limit for the subsequent plan year. CONCLUSION Although the guidance brings welcome news for some non-calendar-year plans, it comes too late for many others. Relying on a reasonable interpretation of “taxable year” as referring to the individual taxpayer’s tax year (which generally is the calendar year), many plan sponsors who have health FSAs with plan years beginning in 2012 but ending after January 1, 2013 have already amended their plans to comply with the $2,500 limit. While plan sponsors have until December 31, 2013 to amend their plan documents to reflect the $2,500 limit, they will need to ensure, as of the first plan year beginning on or after January 1, 2013, that employees may not elect salary reduction contributions to the health FSA in excess of the $2,500 limit. Plan sponsors will want to review their current processes to ensure that the plan will be administered in accordance with the requirements. 3 Willis North America • 06/12
  • 4. KEY CONTACTS U.S. HUMAN CAPITAL PRACTICE OFFICE LOCATIONS NEW ENGLAND ATLANTIC Marietta, GA 770 425 6700 Auburn, ME Baltimore, MD 207 783 2211 410 584 7528 Miami, FL 305 421 6208 Bangor, ME Knoxville, TN 207 942 4671 865 588 8101 Mobile, AL 251 544 0212 Boston, MA Memphis, TN 617 437 6900 901 248 3103 Orlando, FL 407 562 2493 Burlington, VT Metro DC 802 264 9536 301 581 4262 Raleigh, NC 704 344 4856 Hartford, CT Nashville, TN 860 756 7365 615 872 3716 Savannah, GA 912 239 9047 Manchester, NH Norfolk, VA 603 627 9583 757 628 2303 Tallahassee, FL 850 385 3636 Portland, ME Reston, VA 207 553 2131 703 435 7078 Tampa, FL 813 490 6808 Shelton, CT Richmond, VA 813 289 7996 203 924 2994 804 527 2343 Vero Beach, FL NORTHEAST Rockville, MD 772 469 2842 301 692 3025 Buffalo, NY MIDWEST 716 856 1100 SOUTHEAST Appleton, WI Morristown, NJ Atlanta, GA 800 236 3311 973 539 1923 404 224 5000 Chicago, IL Mt. Laurel, NJ Birmingham, AL 312 288 7700 856 914 4600 205 871 3300 312 348 7700 New York, NY Charlotte, NC Cleveland, OH 212 915 8802 704 344 4856 216 861 9100 Norwalk, CT Gainesville, FL Columbus, OH 203 523 0501 352 378 2511 614 326 4722 Radnor, PA Greenville, SC Detroit, MI 610 254 7289 704 344 4856 248 539 6600 Wilmington, DE Jacksonville, FL Grand Rapids, MI 302 397 0171 904 355 4600 616 957 2020 4 Willis North America • 06/12
  • 5. Milwaukee, WI Wichita, KS 414 203 5248 316 263 3211 414 259 8837 WESTERN Minneapolis, MN 763 302 7131 Fresno, CA 763 302 7209 559 256 6212 Moline, IL Irvine, CA 309 764 9666 949 885 1200 Pittsburgh, PA Las Vegas, NV 412 645 8506 602 787 6235 602 787 6078 Schaumburg, IL 847 517 3469 Los Angeles, CA 213 607 6300 SOUTH CENTRAL Novato, CA Amarillo, TX 415 493 5210 806 376 4761 Phoenix, AZ Austin, TX 602 787 6235 512 651 1660 602 787 6078 Dallas, TX Portland, OR 972 715 2194 503 274 6224 972 715 6272 Rancho/Irvine, CA Denver, CO 562 435 2259 303 765 1564 303 773 1373 San Diego, CA 858 678 2000 Houston, TX 858 678 2132 713 625 1017 713 625 1082 San Francisco, CA 415 291 1567 McAllen, TX 956 682 9423 San Jose, CA 408 436 7000 Mills, WY 307 266 6568 Seattle, WA 800 456 1415 New Orleans, LA 504 581 6151 The information contained in this publication is not intended to represent legal or tax advice and Oklahoma City, OK has been prepared solely for educational 405 232 0651 purposes. You may wish to consult your attor- ney or tax adviser regarding issues raised in this Overland Park, KS publication. 913 339 0800 San Antonio, TX 210 979 7470 5 Willis North America • 06/12