The IRS issued guidance last week addressing the $2,500 salary reduction limitation for health flexible spending accounts ("health FSAs"). In Notice 2012-40, the IRS provides guidance on the effective date and how employers should amend their cafeteria plans to comply with the new limit.
Section 125(i) of the Internal Revenue Code (the "Code") was added by Section 9005 of the Patient Protection and Affordable Care Act and limits salary reduction contributions under health FSAs to $2,500 for taxable years beginning after December 31, 2012. The limit is then indexed for cost-of-living adjustments for plan years beginning after December 31, 2013. Failure to comply with this limit will result in the cafeteria plan not qualifying as a cafeteria plan under Section 125 of the Code, which means the value of the taxable benefits an employee could have elected to receive will have to be included in the employee's gross income.
A summary of the guidance in Notice 2012-40 is provided below. Employers should make sure their cafeteria plans operate in compliance with the new health FSA limit and are timely amended.
The Notice provides that for purposes of the effective date provision, the term "taxable year" refers to the plan year of the cafeteria plan and not the individual employee's taxable year. Therefore, the $2,500 limit applies on a plan-year basis and is effective for plan years beginning after December 31, 2012.
Application of $2,500 limit
The salary reduction contribution limit for health FSAs will apply on an employee-by-employee basis. Thus, the maximum an employee can contribute to his or her health FSA will be $2,500, regardless of the number of individuals whose medical expenses are reimbursable under the employee's health FSA (e.g., spouse, dependents or adult children). However, if each spouse is eligible to contribute to a health FSA, then each spouse may make an election to contribute up to the $2,500 limit.
For purposes of the new salary reduction contribution limit, all employers treated as a single employer pursuant to the Code's controlled group and affiliated service group rules are also treated as a single employer. However, if an employee is employed by two or more unrelated employers, then the employee may defer up to $2,500 under each employer's health FSA.
Employer non-elective contributions
Generally, employer non-elective contributions (i.e., flex credits) will not count toward the $2,500 limit. However, if an employer provides flex credits that employees can elect to receive as cash or as a taxable benefit, those flex credits will be treated as salary reduction contributions and will therefore count toward the limit.
Other employer-provided coverage
The $2,500 limit only applies to salary reduction contributions to a health FSA in a cafeteria plan and does not apply to other employer-provided coverage (e.g., dependent care FSAs). The limit also does not apply to salary reduction contributions to a cafeteria plan that are used to pay an employee's share of health coverage premiums, salary reduction contributions to a Health Savings Account (HSA) or to amounts made available by an employer under a Health Reimbursement Arrangement (HRA).
Written plan amendment
The Notice provides an exception to the general rule that cafeteria plan amendments be effective only prospectively and gives employers until December 31, 2014, to adopt an amendment to their cafeteria plan, provided the cafeteria plan operates in accordance with the new requirements for plan years beginning after December 31, 2012.
Relief for erroneous excess contributions
The Notice provides relief for employers in the event an employee is erroneously allowed to elect a salary reduction of more than $2,500 for a plan year, provided the employer timely adopts an amendment (i.e., by December 31, 2014) limiting salary reduction contributions under the health FSA to $2,500. In such case, the cafeteria plan will continue to qualify as a cafeteria plan if (i) the terms of the plan apply uniformly to all participants, (ii) the error results from a reasonable mistake by the employer and is not due to willful neglect by the employer (or the employer's agent) and (iii) salary reduction contributions in excess of the limit are paid to the employee and reported as wages for income tax withholding and employment tax purposes on the employee's Form W-2 for the employee's taxable year in which, or with which, ends the cafeteria plan year in which the correction is made.