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RED ALERT good NEWS 05/18/05 - The Bush administration is relaxing the "use-it-or-lose-it" rule! Per Notice 2005-42, issued 05/17/05, Treasury & IRS have eased the rule so that employees can use FSA balances that remain at the end of a plan to pay for health care and dependent care expenses incurred during the first 2½ months of the following plan year. The new grace period goes into effect immediately. Employers wanting to adopt the grace period will have until the end of the current plan year to amend their plan documents. Treasury Secretary John Snow said the change in policy "will ease the spending rush prompted" by the use-it-or-lose-it rule. This extended "grace period" for participants to use up their health FSA or DCAP balances will reduce forfeitures, but might cause administrative and compliance issues for employers and administrators. Ordinarily, the spending of unused amounts after the plan year would result in deferred compensation to the employee, in violation of the tax code. However other areas of tax law provide that for a short, limited period, compensation for services paid in the year following the year in which those services were performed is not treated as deferred compensation. Unused FSA amounts should be treated consistent with these other areas of the law. The grace period must apply to all plan participants. Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year only. The period must not extend beyond the 15th day of the third calendar month after the end of the immediately preceding plan year to which it relates. The plan cannot permit cash-out or conversion of unused benefits or contributions, during the graced period, to any other taxable or nontaxable benefit.   For Example: Assume a 2005 calendar year plan document is amended to include the grace period (extending to 3/15/06), unused FSA funds from the 2005 plan year where they incur qualifying expenses during the grace period may be reimbursed for those expenses from unused 2005 funds.  -- Participants can be given up to 14 months, 15 days to use the benefits or contributions for a plan year before unused amounts are forfeited. If a grace period is adopted, systems will have to be set up to ensure that expenses incurred during the grace period are reimbursed first from the preceding year's account balance (if any). The grace period extends the when expenses may be incurred; it is different from a claims run-out period, which extends the time for submitting expenses. Employers that adopt a grace period need to extend the claims run-out period under their plans to coordinate with the grace period.   No Cash-Out, Conversion, or Carryforward: Unused amounts cannot be cashed out or converted to other benefits during the grace period, i.e., a participant's unused DCAP amounts cannot be used to pay or reimburse health care expenses incurred during the grace period (only unused health FSA amounts can be used to reimburse those expenses). If the unused amounts are not used to pay or reimburse expenses incurred during the grace period, they cannot be carried forward for use in future plan years but must be forfeited.  Plans that are amended to provide a grace period will administrative and recordkeeping challenges & potential COBRA, ERISA, and other compliance issues.

A cafeteria plan is a written plan that allows participating employees to select qualifying benefits from a "menu" of choices. The participant can direct a portion of their salary to the plan. The redirected salary is "banked" by the employer in an account maintained for the employee. When an expense is incurred for a qualifying benefit, the employee is reimbursed by the employer with dollars in the "banked" account. Reimbursements provide additional benefits to the employee, because they escape Federal, state, local, and social security taxation. Flex-credit plans offer even more employee choice and additional tax savings plus they are inexpensive to start and administer and the benefits will help retain employees. With cafeteria plans employees can use pre-tax dollars to pay for benefits, like health insurance & dependent care & both the employee and employer may save three kinds of taxes:

  1. Federal income taxes

  2. FICA taxes

  3. State and local taxes

Employees do not pay federal income tax or FICA (Social Security & Medicare) on cafeteria plan elections for pre-tax salary reductions. (The employee share of FICA is generally 7.65% of wages, subject to statutory wage limits & the employer saves these taxes also!) Most state & local governments treat cafeteria plan salary reductions favorably for state & local income tax purposes but this varies by state. An employee’s actual savings will depend upon their tax status, taxable income, pre-tax salary reductions, state & local laws, and the cafeteria plan features. Employers also save FICA tax & this tax reduction can be used to offset the cost of administering the plan. The tax savings make cafeteria plans VERY attractive (even to small employers).

AASC Provides consultation, design and implementation for all phases of cafeteria plan’s including:

  • Flexible spending accounts
  • Full-Flex, including FlexCash (FLEX-CREDITS or FLEX-DOLLARS) 
  • Medical reimbursement accounts
  • Dependent care accounts (DCAp account tax information)
  • Premium Only Plans (POP)
  • Drafting plan documents, summary plan description, employee forms
  • Bimonthly plan administration
  • Debit card claims processing to simplify claims (HIPAA & Debit Cards press release)
  • IRS Debit card claims guidance (pdf file)
  • Check printing
  • Annual preparation of IRS form 5500
  • Annual nondiscrimination testing and compliance

Full-Flex brochure, (pdf file) a Graphic illustration of the American Administration Full-Flex plan design

A technical five page brochure (White Paper) that explains our FlexCash concept in more detail

Examples of allowable Flex Plan status changes events

  • A 1 page (.pdf file) partial listing of FSA eligible Medical expenses

  • IRS Publication 502, Medical and dental expenses (see Pages 4 thru 14 for an official IRS list) (.pdf file)  Tax Treatment of some items were modified and are addressed in the 2003 Pub. 502, for example: Nutritional Supplements, plans may now  reimburse both prescription and non-prescription medicines, Weight-Loss Program (revised rules), Self-Employed Health Insurance Deduction Rate for 2003 is increased from 70% to 100% (self-employed cannot participate in a cafeteria plan), Special Education, Veterinary Fees, seeing-eye dogs, and the Health Coverage Tax Credit (HCTC) was revised exercise caution. Portions of Pub. 502 would provide the wrong result if applied to health FSAs, HSAs, and health reimbursement arrangements (HRAs) in some cases. That's because Pub. 502 is designed to address what expenses are deductible, but it does not describe the different restrictions that apply for expenses to be reimbursable under health FSAs, HSAs, and HRAs & The "no double-dipping" rule for health FSAs is not new, but this is the first time it's been mentioned in Pub. 502.

  •  The Benefits Test [Code Section 105(h)] requires that the benefits provided under a health FSA not discriminate in favor of participants who are highly compensated individuals (HCIs). An HCI is an individual who is (1) one of the five highest-paid officers; (2) a shareholder who owns (under certain ownership attribution rules) more than 10% of the value of the employer's stock; or (3) among the highest-paid 25% of all employees (with certain exclusions).

    Sec. 105(h)] prohibits both discriminatory benefits on the face of the plan and discriminatory benefits in operation.

    1. The required employee contributions must be identical for each benefit level. Assuming your company has a health FSA under which non-HCIs who contribute $2,400 per year receive $2,400 of coverage, but HCIs who contribute $2,400 per year receive $3,000 of coverage. Your health FSA would fail the Benefits Test.
    2. The maximum benefit level that can be elected cannot vary based on age or years of service. Providing a higher level of benefits (e.g., more coverage for certain individuals, lower contributions for the same coverage, etc.) for individuals based on their age could violate the Benefits Test, if any of them are HCIs. A similar problem is created by linking benefits to years of service. Assuming you make a contribution to each participant's health FSAequal to $20 multiplied by each year of employment or $300, whichever is less. Some HCIs with long tenure would receive more benefits than non-HCIs would, and your health FSA would fail the Benefits Test.
    3. The type or amount of benefits subject to reimbursement cannot be in proportion to employee compensation. A health FSA that limits the annual amount of reimbursement available to employees to a percentage of their compensation would violate the Benefits Test if HCIs participate.
    4. The same types of benefits (e.g., reimbursable medical expenses) available to HCIs must be available to non-HCIs on at least as favorable terms. A health FSA cannot exclude orthodontia expenses for non-HCIs while covering them for HCIs.
    5. Health FSAs cannot impose disparate waiting periods. Your health FSA can not require non-HCIs to wait 30 days to enter the plan after becoming eligible (for ex.), while allowing HCIs to enter the plan immediately. Under the "no discriminatory benefits in operation" subtest, a health FSA must not discriminate in favor of HCIs in actual operation. This is a "facts and circumstances" determination. Such discrimination could arise, for example, if the administrator approves certain claims submitted by HCIs while denying similar types of claims for non-HCIs (e.g., by requiring less substantiation from HCIs than from non-HCIs without having justifiable reasons for treating their claims differently). Note: The plan features described above are only examples--other features may also cause a health FSA to fail the Benefits Test.  In addition, health FSAs are subject to an Eligibility Test under Code Section 105(h). And a health FSA that is offered under a cafeteria plan (as most health FSAs are) will be subject to additional nondiscrimination rules under Code Section 125. Health FSA nondiscrimination testing requirements are complex and need careful monitoring--most employers engage TPAs for assistance.
  • IRS News Release IR-2003-108 (pdf file) about allowing Over The Counter (OTC) Drug reimbursements
  • IRS Revenue Ruling 2003-102 (pdf file)
  • An introduction to cafeteria plans by the IRS Office of Chief Counsel
  • IRS Publication 15-B, an Employer's Tax Guide to Fringe Benefits (2004 Version) (24 page .pdf file)

Parking plans are allowed under IRC Section 132 and allow pretax reimbursements for qualified parking claims. These are currently available for reimbursement:

  • Transportation in a commuter highway vehicle if such transportation is in connection with travel between the employee’s residence and place of business;
  • Any transit pass (i.e. pass, token, farecard or voucher);
  • Qualified parking. The term ‘qualified parking’ means parking provided to an employee on or near the business premises of the employer or on or near a location from which the employee commutes to work by a commuter highway vehicle or carpool.
AASC can also design and administer a Defined Contribution Style Health Care system to control healthcare costs. (How is your HIPPA Policy doing?) 

HIPAA Privacy Rule information

Wall Street Journal article about Flexible Spending Accounts (pdf file)


Technical Compliance Issues

Cafeteria plans (and all benefits offered under them) must pass some nondiscrimination tests

These requirements are generally intended to prevent plans from discriminating in favor of highly-compensated employees (HCEs) and key employees. All employers must comply. There is no blanket exemption for cafeteria plans sponsored by governmental entities, churches, or tax-exempt organizations, although nondiscrimination testing of such plans may raise special issues (tax-exempt organizations will not have any "owners" to include in the group of HCEs or key employees).

Three nondiscrimination tests apply to current cafeteria plans:

  1. Eligibility Test (a cafeteria plan cannot discriminate in favor of highly-compensated individuals as to eligibility to participate);

  2. Contributions and Benefits Test (a cafeteria plan cannot discriminate in favor of highly-compensated  participants as to contributions and benefits); and

  3. Key Employee Concentration Test (nontaxable benefits provided to key employees under a cafeteria plan cannot exceed 25% of the nontaxable benefits provided for all employees under the plan). If a health FSA is added, two more tests will apply (an Eligibility Test and a Benefits Test); if a DCAP is added, there will be four additional tests (Eligibility, Contributions and Benefits, More-Than-5% Owners Concentration and 55% Average Benefits Tests).

Although varied and complicated, these tests possess three common themes: eligibility, availability and utilization  

You should address nondiscrimination testing immediately -- discrimination problems cannot be resolved through corrections made after the end of the plan year. If your plans don't pass (i.e., it is discriminatory), then HCEs or key employees, are subject to tax on the amount of their salary reductions under the plan. (non-HCEs and non-key employees will not be taxed and the cafeteria's plan status under Code Section 125 should not be affected.)  See: IRS Publication 502

What's on the technical compliance horizon for cafeteria plans? 

NEWS Apr-08-2005: US Senator Olympia Snowe (R-Maine) has introduced the SIMPLE Cafeteria Plan Act of 2005 to amend the tax code so that small businesses and their employees could buy employer-provided health insurance with pretax dollars. S723, is modeled after the Savings Incentive Match Plan for Employees (SIMPLE) pension plan enacted in 1996 and is aimed at helping small companies that typically cannot satisfy cafeteria plan rules due to testing and eligibility problems. And would permit a carryover of unused flexible spending accounts funds & simplify & increase dependent care accounts for employers. Sen. Jim DeMint’s S.309 (permitting $500 to be rolled over) has been referred to the Senate Finance Committee for action. Snowe is expected to hold hearings soon on her association health plan measure, S.406, Small Business Health Fairness Act of 2005.  That measure, which amends ERISA, would allow small businesses to pool together, nationally, through trade associations, to create Association Health Plans (AHPs) and either purchase their health insurance from a provider, or to self insure.

NEWS Apr-01-2005: use-it-or-lose-it - Most employers support ending the requirement that employees use their FSA contributions or forfeit them. Origins: The use-it-or-lose-it rule was designed to have employer and employee share the risk associated with FSAs, says Michael Thrasher, counsel of the Groom Law Group (former IRS attorney). He is familiar with the rules because he helped write them in the 80s when he served as assistant chief counsel for employee benefits and exempt organizations. He says the idea was to make the regulation as much like insurance as possible. The employee starts with less risk, and it goes up during the year. The employer starts with a higher level of risk, and it goes down as the year progresses. The risk to employers is an employee's anticipated annual contribution is available immediately however, EE contributions are amortized throughout the year. An EE could commit to an annual contribution of $1,200 in January, spend it in February & terminate in March generating ER's potential risk level of about $900.

Bonnie Whyte, president of the Employers Council on Flexible Compensation (ECFC) advocates reform; the "IRS views spending accounts just like an insurance policy - you buy it, it is good for the year but most EEs  consider their FSA as a reimbursement account," she says. "Use-or-lose-it is a disincentive for some EEs." She understands the Treasury Department's reluctance to act on the FSA issue, because HSAs are a Bush favorite. But, regarding HSAs, "The one-size-fits-all approach to health care will not work for everyone in our diverse country". FSAs work well in conjunction with a numerous medical plan designs but HSAs are limited to specific high-deductible plans. Forcing an employee from a major medical plan or HMO with $20 copays to a qualifying high-deductible health plan is challenging & might create EE-relations problems. "That is a fairly radical shift. Sometimes you have to do things in steps - moving to higher deductible plans incrementally rather than cold turkey," Whyte says. More employers are setting up health reimbursement arrangements with employer funds to introduce more consumer-driven concepts to their employees. One current reform proposal allows EEs to carry over $500, but support exists for more generous proposals.

--NEXT--

 

NEWS Jun-23-2004: House Passes Bill Allowing More Child Care Savings - The House passed a bill that would allow families to keep unspent money they saved that year in tax-free child care accounts. H.R. 4372, the "Working Families Assistance Act of 2004," would apply to taxable years beginning after Dec. 31, 2003.  H.R. 4372 joins H.R. 4279, which the House passed earlier this year, to provide for the disposition of unused health benefits in cafeteria plans and FSAs. Both measures are now before the Senate. If enacted, they would force a fundamental change in how dependent care and health FSAs are administered, as participants are currently prohibited from carrying over any unspent moneys into the next plan year. Currently, employees have to give up any money that remains unspent in their flexible spending accounts at the end of the year. Under the bill, passed by voice vote, families will be able to roll over up to $500 in unused child care savings to the next year. "These accounts are not being utilized to their full extent," said U.S. Rep. Eric Cantor, R-Va. He said the "use it or lose it" rule hurts families who could use the roll-over benefit to ensure their child care bills can be paid. U.S. Rep. Benjamin Cardin, D-Md., said Congress should do more to help people care for children and dependent adults. The bill corrects a flaw in the existing system, however. "You have to determine in a year how much money you are going to spend," he said. "If you put in too much money, you are going to lose that money." The money in flexible spending accounts can be used to pay for care for disabled spouses, parents or dependent adults. Earlier this year, the House passed a similar bill allowing employees to roll over to the next year up to $500 in unused money set aside in flexible spending accounts for health care. 

END

House to vote on FSA carry-overs - The House next week is expected to vote (in May04) on newly introduced legislation that would allow employees to carry forward up to $500 a year in unused health care flexible spending account balances. Alternatively, up to $500 in unused balances could be contributed to a health savings account, if the employer maintained one. The bill would modify the current “use it or lose it” requirement for FSAs, would encourage more employees to contribute to FSAs, said sponsor Rep. Jim McCrery, R-La., adding that FSA utilization allows employees to pay health expenses in a tax-effective way. H.R. 4279, is similar to a bill included in the Medicare prescription drug bill the House-passed last year. However, the provision was stripped by congressional conferees from the final bill.

These merely represent "to do" lists of regulatory items. Some of these items may affect Cafeteria Plans but are merely carry-overs from the Treasury Department's previous Semiannual Regulatory Agenda from May 2003 & the 2003-2004 Priority Guidance Plan from July 3002:

  • Dependent Care Credit. Proposed regulations to amend existing but partially obsolete regulations under Code Section 21.

  • Definition of "Highly Compensated Employee." Proposed regulations under Code Section 414(q).

  • Final regulations providing information about the tax treatment of cafeteria plans.

  • The Treasury Department has also issued its first quarterly update of the 2003-2004 Priority Guidance Plan, which lists other types of guidance that are being developed (in addition to regulations), such as revenue rulings and revenue procedures and the following may also affect Cafeteria Plans:

  1. Guidance on the election between taxable and nontaxable benefits.

  2. Guidance on debit cards.

  3. Guidance under Code Section 3121 regarding the definition of salary reduction agreement.

  4. Final revenue procedure under Code Section 23 regarding the credit for adoption expenses.

  5. Guidance under Code Section 32 regarding earned income.

[Dept. of the Treasury Semiannual Regulatory Agenda, 68 Fed. Reg. 73362 (Dec. 22, 2003); Dept. of the Treasury First Quarterly Update of the 2003-2004 Priority Guidance Plan (Nov. 3, 2003)] Agenda: http://a257.g.akamaitech.net/7/257/2422/22dec20031200/edocket.access.gpo.gov/ua031222/pdf/ua031016.pdf  and Priority Guidance Plan: http://www.irs.gov/pub/irs-utl/2003-2004pgp.pdf

HSAs in a cafeteria plan

New Medicare legislation provides tax-advantaged health savings accounts (HSAs) for virtually anyone who has coverage under a high-deductible health plan. In a surprising twist, the law allows HSAs to be funded on a pre-tax basis through a cafeteria plan, opening a whole new avenue for funding consumer-driven health care. Generally, cafeteria plans cannot include a benefit that provides coverage in future years. However, the legislation specifically permits HSAs to be offered under a cafeteria plan. Therefore, individuals may make contributions to the HSA with pre-tax salary reductions, even though the contributions may be carried over to future years. The pre-tax salary reductions are treated as "employer" contributions and may not be deducted on an individual tax return. As with any new legislation, the Medicare act leaves a few loose ends that require further regulatory clarification. For example, it is not clear what restrictions will be placed on mid-year changes to salary reduction elections for HSAs that are part of a cafeteria plan. In addition, the legislation does not state whether employer-funded HSAs will be subject to the substantiation requirements currently applied to health FSAs. The IRS has indicated that it will provide guidance on HSAs very soon. Additional guidance from the Labor Department is necessary to determine ERISA coverage and related issues.

NEWS Update: May 12. 2004, The House of Representatives approved HR 4279 by a vote of 273-152 with 50 Democrats supporting the measure. The measure would allow up to $500 in a Flexible Spending Account (FSA) to be carried over from year to year; and will allow up to $500 in an FSA to be contributed to a health savings account (HSA). Rep. Jim McCrery (R-La) introduced the bill only one week before its House passage. The Senate now must take up the measure. If it is enacted, the bill's provisions will apply to taxable years beginning after Dec. 31, 2003.  Read: HR 4279 to allow $500 annual FSA rollover.

NEWS Update: Aug. 23, 2004,  Grassley urges end to ‘use it or lose it’ for FSAs (1 page .pdf) - The chairman of the Senate Finance Committee is urging the Treasury Department to re-examine a decades-old rule that requires employees with flexible spending accounts to forfeit any unused FSA funds at the end of each year. The so-called “use it or lose it” rule results in the inefficient use of health care dollars, says Sen. Charles Grassley, R-Iowa. That rule gives employees an incentive “to incur unnecessary health care expenses at the end of the year to use up the account,” Sen. Grassley wrote in a letter sent Monday to U.S. Treasury Secretary John Snow. In addition, Sen. Grassley noted there is “no other area of benefits law in which we allow—let alone mandate—that employee dollars set aside for benefit expenses revert back to the employer.” The Bush administration has supported modifying the rule so employees could roll over up to $500 in unused funds. The House has passed the proposal, but the Senate has not acted on it.

NEWS Update: Feb. 14, 2005, A bipartisan US Senate group has proposed allowing workers to carry forward up to $500 in unused Flexible Spending Account (FSA) funds to the next year or move the money to a Health Savings Account (HSA). Senator Jim DeMint (R-SC) sponsored The Flexible Spending Account Enhancement Act of 2005 (S 309) with Senators Ken Salazar (D-CO) and John Ensign (R-NV)  - "FSAs are already very helpful tools, but we can make them even better," DeMint said in the statement. "These accounts allow people to save for unforeseen medical expenses. "Giving employees the ability to rollover funds to the next year will encourage more people to participate in FSAs because they can better manage their hard-earned money," said Salazar. "We have to start allowing Americans to better save for their own health care and give individuals more control over their health care decisions." DeMint said he had introduced the bill in the House where it was approved in May 2004, but later died in the Senate. http://demint.senate.gov/index.cfm?FuseAction=PressReleases.Detail&PressRelease_id=228

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