April 8, 2014
Authored by: Chris Rylands
Recently, the IRS released a Chief Counsel Advice Memo describing the interaction of the health FSA carryover feature we previously discussed and HSAs. This memo addresses some of the important questions left open by prior guidance. However, readers should know that CCA Memos are not binding guidance, so while this memo is helpful, employers should recognize that subsequent IRS guidance may take a different approach.
The question raised was whether an employee in a general purpose FSA with a carryover feature can contribute to an HSA. The answer (a good legal answer) is, “it depends.”
The CCA starts out by noting, correctly, that an individual who is covered under a general purpose health FSA (i.e. one that reimburses for more than just dental, vision, preventive care, and post-HDHP deductible expenses) is not eligible to contribute to an HSA. So a general purpose carryover makes the individual HSA-ineligible. This applies even after the entire $500 (or other amount) carried over is spent. So if a participant who carried over $500 from a prior year goes for laser eye surgery in January and uses up the general purpose carryover amount, he or she is still ineligible for the entire year. So far, this is consistent with guidance involving the grace period, so there is no real surprise here.
But then the CCA goes on to say that an individual who elects a limited purpose, HSA-compatible FSA (i.e. one that reimburses only for dental, vision, preventive care, or post-deductible expenses, or some subset of those) can carryover the $500 from a general purpose FSA into the limited purpose FSA. In other words, if I have a general purpose FSA in 2014 and want to contribute to an HSA in 2015, I can take my carryover amount from my 2014 general purpose FSA and elect to treat it as a limited purpose FSA in 2015. A plan can also automatically provide this result, without the requirement for a participant election. The CCA also says the participant can elect to waive the carryover entirely.
That is where the carryover diverges from the grace period. (The CCA even alludes to this in a footnote.) Under an IRS-created rule, any rules that apply to grace period reimbursements must apply uniformly all participants. The IRS has interpreted this to mean that the grace period has to be either general purpose or limited purpose for all participants, regardless of which type of FSA they utilized during the plan year. There are structuring alternatives that may serve to limit the scope of this rule, but it nevertheless constitutes a trap for the unwary since it does not allow variations on a participant-by-participant basis, as this new (admittedly, informal, non-binding) guidance does for the carryover. Note this grace period rule is an IRS-created rule, so the IRS could change it, but has chosen not to (for reasons known only to themselves).
While this new rule on the carryover is good news for employers wanting to implement the carryover, it also only serves to highlight the very trap for the unwary that the grace period rules create. Employers weighing the choice between having (or keeping) a grace period or implementing the carryover should take this into account, as it would be significantly simpler for employees to understand. Employers should also consider that this rule is informal and non-binding, so the IRS could take a different position in formal guidance. However, to the extent the IRS does so, we expect any different interpretation would be prospective-only.