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Flexible Spending Arrangements

  • 3515. What is a flexible spending arrangement?

    • A flexible spending arrangement (FSA) is a program under IRC Section 125 under which incurred expenses may be reimbursed. This benefit may be provided as a stand-alone plan or as part of a traditional cafeteria plan. The most common types are health FSAs (Q 3516) and dependent care assistance FSAs (Q 3517).

      In order for the coverage provided through an FSA to qualify for the exclusion from income under IRC Sections 105 and 106 (for health FSAs, see Q 332, Q 334) or IRC Section 129 (for dependent care FSAs, see Q 3625), the FSA must meet the requirements set forth in Q 3516 and Q 3517.

  • 3516. What is a health flexible spending arrangement?

    • Editor’s Note: Health FSAs typically operate under a “use it or lose it rule.” As participants know, FSA amounts not used by the end of a grace period following the year-end are typically forfeited. Plans are also permitted to allow a $570 ($610 in 2023) per-year carryover. Late in 2020, Congress enacted the CAA, which allowed amendments to health FSAs and dependent care FSAs to permit participants to carry over any unused amounts from the 2020 plan year into the 2021 plan year. FSAs with plan years ending in 2021 were similarly permitted to allow participants to carry over all unused amounts into plan years ending in 2022. If the plan already had a grace period in place, the grace period could be extended to 12 months after the end of the plan year. Relatedly, FSAs were permitted to allow employees who stopped participating in the FSA during 2020 or 2021 to continue receiving amounts from the FSA through the end of the year in which the employee stopped participating (including any grace periods and extended grace periods).

      Although health coverage under an FSA need not be provided under commercial insurance, it must demonstrate the risk shifting and risk distribution characteristics of insurance. Reimbursements under a health FSA must be paid specifically to reimburse medical expenses that have been incurred previously. A health FSA cannot operate so as to provide coverage only for periods during which the participants expect to incur medical expenses, if such period is shorter than a plan year. In addition, the maximum amount of reimbursement must be available at all times throughout the period of coverage (properly reduced for prior reimbursements for the same period of coverage), without regard to the extent to which the participant has paid the required premiums for the coverage period, and without a premium payment schedule based on the rate or amount of covered claims incurred in the coverage period.1 Before 2013, there was no statutory limit on contributions to a health FSA, but most employers imposed a limit to protect themselves against large claims that had not yet been funded by salary reductions.

      The period of coverage must be 12 months, or in the case of a short first plan year, the entire first year (or the short plan year where the plan year is changed). Election changes may not be permitted to increase or decrease coverage during a coverage year, but prospective changes may be allowed if they are consistent with certain changes in family status. See Q 3506. The plan may permit the period of coverage to be terminated if the employee fails to pay premiums, provided that the terms of the plan prohibit the employee from making a new election during the remaining period of coverage. The plan may permit revocation of existing elections by an employee who terminated service.2

      A plan may provide a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement. The grace period must apply to all participants in the plan. Plans may adopt a grace period for the current plan year by amending the plan document before the end of the current plan year.3 Further, beginning in 2014, health FSAs may be amended so that $500 of each participant’s unused amounts remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carryover provision may not also offer the 2½ month grace period.4

      In 2020, the IRS clarified that the amount that may be carried forward will be inflation-adjusted, so that the amount that can be carried over to the following year from a health FSA will equal 20 percent of the maximum inflation-indexed salary reduction amount under Section 125 (increasing the carryover amount to $610 in 2023).5 This change, while enacted in the wake of the COVID-19 pandemic, is permanent.

      Planning Point: The IRS has released guidance clarifying application of the carryover provision. The IRS guidance has made clear that, unlike health savings accounts (HSAs) or health reimbursement arrangements (HRAs), the FSA cannot allow the participant to accumulate funds from year to year. The carryover applies only to the single year that immediately follows the year of contribution.6

      The plan may reimburse medical expenses of the kind described under IRC Section 213(d), but may not reimburse for premiums paid for other health plan coverage.7

      Editor’s Note: Under current law, the plan can reimburse for nonprescription over-the-counter drugs.8 However, for taxable years beginning after December 31, 2010 and before March 2020, reimbursements for medicine were limited to doctor-prescribed drugs and insulin. That requirement was repealed by the 2020 CARES Act in the wake of the COVID-19 pandemic.9

      The medical expenses must be for medical care provided during the period of coverage with substantiation that the expense claimed has been incurred and is not reimbursable under other health coverage.10

      Planning Point: Employees should remember that health expenses are deemed to be “incurred” when the service is actually provided–not when the employee is billed.

      The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred, provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.11 On a one-time basis, a plan may allow a qualified HSA distribution. See Q 413.

      Employer-provided coverage for qualified long-term care services provided through an FSA is included in the employee’s gross income.12

      Informal IRS Guidance on FSAs. In August of 2001, the IRS provided informal, nonbinding guidance regarding FSAs. In a departure from previous informal guidance, the IRS indicated that orthodontia expenses should be treated differently from other medical expenses. Under this reasoning, if orthodontia expenses are paid in a lump sum when treatment commences, rather than over the course of treatment, they could be reimbursed under an FSA when paid. Finally, the IRS informally clarified that there is no de minimis claim amount that need not be substantiated; employers and plan administrators may not disregard the substantiation requirements for small claims.

      1.     Prop. Treas. Reg. § 1.125-5(d).

      2.     Prop. Treas. Reg. § 1.125-5(e).

      3.     Prop. Treas. Reg. § 1.125-1(e); Notice 2005-42, 2005-1 CB 1204.

      4.     Notice 2013-71, 2013-47 IRB 532.

      5.     Notice 2020-33.

      6.     IRS INFO 2018-0012.

      7.     Prop. Treas. Reg. § 1.125-5(k).

      8.     Rev. Rul. 2003-102, 2003-2 CB 559.

      9.     IRC § 106(f), as added by ACA 2010.

      10.    Prop. Treas. Reg. § 1.125-6(b); Rev. Proc. 2003-43, 2003-1 CB 935. See Grande v. Allison Engine Co., 2000 U.S Dist. LEXIS 12220 (S.D. Ind. 2000).

      11.    Notice 2006-69, 2006-2 CB 107. See also Notice 2007-2, 2007-1 CB 254.

      12.    IRC § 106(c)(1).

  • 3517. What is a dependent care flexible spending arrangement?

    • Editor’s Note: The American Rescue Plan Act (ARPA) allowed employers to increase contribution limits for dependent care assistance programs (DCAPs) or dependent care FSAs to $10,500 for 2021. The 2021 CAA also allowed participants to carry over unused DCAP benefits from 2020 or 2021 into the following plan year. Initially, there was some confusion over the tax consequences if a participant took advantage of both the increased contribution limit and carryover relief. Notice 2021-26 clarified the issue by providing that participants could take advantage of both (1) tax-free reimbursements of contributions made during the 2021 plan year up to the maximum $10,500 limit and (2) tax-free reimbursements of amounts carried over from the prior year. In other words, a participant with a $5,000 carryover amount from 2020 and a $10,500 contribution in 2021 could take tax-free distributions up to $15,500 in 2021 if that participant incurred enough qualifying expenses during the 2021 plan year.

      Substantially the same rules apply to dependent care FSAs as health FSAs, except that the maximum amount of reimbursement need not be available throughout the period of coverage. A plan may limit a participant’s reimbursement to amounts actually contributed to the plan and still available in the participant’s account.1 Contributions to a dependent care FSA may not exceed $5,000 during a taxable year.2

      Planning Point: With so many employees working from home in 2020 and 2021, many employees began rethinking contributions to dependent care FSAs. The rules governing changes to dependent care FSA contributions are more flexible than health FSAs. Employees are permitted to make mid-year changes in pre-tax contributions if their circumstances relating to the need for dependent care changes. Employees can reduce their contributions if they are working from home and do not need childcare, or they can increase the contributions when they return to work and need to provide for increased childcare costs.

      Further, employees who were furloughed or laid off might have asked whether their plan contains a spend-down feature. These features are optional but allow former employees to seek reimbursement for dependent care expenses incurred through the end of the tax year (even if their employment was terminated). Employers have the option of adding a spend-down feature at any time.

      Like a health FSA, a dependent care FSA may permit a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement.3 The $500 carryover rule applicable for health FSAs after 2013, however, is not available for participants in a dependent care FSA.

      The IRS has also approved the use of employer-issued debit and credit cards to reimburse for recurring dependent care expenses. Because expenses may not be reimbursed until the dependent care services are provided, reimbursements through debit cards must flow in arrears of expenses incurred.4

      1.     Prop. Treas. Reg. § 1.125-5.

      2.     IRC § 129(a)(2)(A). This limit is not currently adjusted for inflation.

      3.     Notice 2005-42, 2005-1 CB 1204.

      4.     Notice 2006-69, 2006-2 CB 107.

  • 3518. How are gains or income from a flexible spending arrangement treated?

    • Any gain or income from an FSA may be (1) used to reduce premiums for the following year; or (2) returned to the premium payors as dividends or premium refunds on a reasonable basis, but in no case based on their individual claims experience.1

      The maximum amount of reimbursement for a period of coverage under an FSA may not be substantially in excess of the total “premium” for the coverage. The maximum amount of reimbursement is not considered to be substantially in excess of the total premium if the maximum amount is less than 500 percent of the premium. This definition is applicable to plan years beginning after December 31, 1989.2

      Since 2013, there are two possible plan options for a participant with unspent funds in a health FSA. The plan may (1) allow for a carryover of up to $500 to the next year, but forfeit amounts in excess of $500 ($610 in 2023, $570 in 2022, $550 in 2020-2021), see Q 3516 at year end; or (2) allow for a grace period giving participants up to an additional 2½ months (through March 15) to spend the unused funds, but forfeit any remaining at the end of the grace period. The employer can offer either option, but not both. Or it can offer neither option resulting in forfeiture of all unspent funds at end of year.

      1.     Prop. Treas. Reg. § 1.125-5(o).

      2.     Prop. Treas. Reg. § 1.125-5(a).