Just before rushing out the door to hand out candy to trick-or-treaters, the IRS gave the benefits world a treat and released Notice 2013-71 which modified the use-it-or-lose-it rule for health FSAs.  The notice generally provides that a cafeteria plan may be amended to provide a carryover of up to $500 of unused amounts into a subsequent plan year.  The $500 amounts may come from employer or employee contributions.  The carryover may only be applied in the immediately following plan year, so if it is not used then, it will be forfeited.

Any remaining amounts at the end of the plan year can still be reduced during the plan’s run-out period before the carryover is applied.  For example, if a plan has a run-out period ending March 31 and a participant submits an expense incurred in the prior year before March 31, that would reduce the prior year’s amount (just as it does now), which would reduce the carryover.  Plans can (and should) provide that amounts used in that following plan year will first be applied against the carried over funds before applied against current year contributions.

A health FSA can have this carryover feature, or a grace period, but not both.  The plan must be amended before the end of the year to implement the carryover feature.  The carryover feature does not apply to other kinds of FSAs.

One issue not addressed in the guidance is whether a health FSA with a carryover feature of $500 that also has employer contributions can continue to qualify as an excepted benefit under HIPAA (and thus also remain exempt from health reform).  Under applicable regulations, a health FSA is exempt from HIPAA portability rules and health reform if the maximum amount that can be reimbursed under the health FSA is the greater of (1) two times the participant’s salary reduction or (2) the participant’s salary reduction plus $500 and other major medical coverage is available.  So assume a participant elects $200 of salary reductions and receives a $500 carryover and a $100 nonelective contribution from the employer.  Does this make the health FSA subject to HIPAA portability and health reform?  The Notice does not address this issue, so additional guidance would be welcome.  Pending further guidance, plan sponsors should consult with counsel before adopting a carryover feature if they (the sponsors, not counsel) also provide nonelective contributions.

Is the IRS  bending the statute by issuing this guidance?  Section 125(d)(2) provides “The term ‘cafeteria plan’ does not include any plan which provides for deferred compensation.”  There are exceptions for specific items, like 401(k) and HSA contributions.  The IRS used these exceptions to say that “a § 125 cafeteria plan generally does not include any plan that provides for deferred compensation.” (emphasis supplied to the additional word supplied by the IRS).  In doing so, the IRS’s “trick” was to use the statutory exceptions to create another exception which does not seem to be expressly permitted under the statute.  No one is likely to challenge this new exception, much like no one challenged  the grace period; however,  the grace period had some basis in other areas of tax law that provide amounts are not deferred compensation if paid or received within 2 1/2 months after the end of the tax year.  Here, the IRS doesn’t seem to have any other tax principle on which to hang its hat.

But legal niceties aside, it remains to be seen how useful this carryover feature really is.  Since it cannot coexist with the grace period in the same plan, plan sponsors will have to decide which feature is more beneficial to their participants.  For example, if most participants elect around $500 for the FSA, the carryover feature may be more beneficial than the grace period.