Question: Can the employer make an exception for an employee who fails to submit dependent care FSA claims by the end of the plan’s run-out period? Could they extend the plan’s run-out period?
Compliance Team Response:
Unfortunately, where an employee fails to submit dependent care FSA expenses prior to the end of the plan’s run-out period, nothing can be done without jeopardizing the entire tax-advantaged status of the Section 125 cafeteria plan for all employees.
Here’s an overview of the concerns:
- Section 125 Use-It-Or-Lose-It Rule
The health and dependent care FSAs are components of the company’s Section 125 cafeteria plan. Internal Revenue Code §125 (and its implementing regulations) imposes very strict limitations on the administration of cafeteria plans. One of the most fundamental of these limitations is that all FSA elections are subject to the use-it-or-lose-it rule. This means that after the end of the plan year (or earlier termination of employment) and any grace and/or run-out period, any remaining unreimbursed funds not subject to a carryover provision must be forfeited to the plan.
- Plan Disqualification Risk
Unfortunately, there is no option for employers to make exceptions to these rules or refund to employees any unreimbursed FSA amounts remaining at the end of the plan year plus any related grace period and/or run-out period (or after the run-out period following termination of employment). Engaging in this practice would risk disqualifying the entire Section 125 cafeteria plan if discovered by the IRS, resulting in all elections becoming taxable to all employees.
- Permitted Use of Experience Gains from Forfeitures
The Section 125 regulations generally provide the following permitted plan uses of experience gains resulting from forfeitures:
(A) To reduce required salary reduction amounts for the immediately following plan year, on a reasonable and uniform basis;
(B) Returned to the employees on a reasonable and uniform basis; or
(C) To defray expenses to administer the cafeteria plan.
Refunding the employee for the remaining unspent amount is not permitted. As a practical matter, employers almost always apply experience gains from forfeitures to the FSA’s plan administrative expenses.
- Amending the Plan Run-Out Period
It is possible to amend the company’s Section 125 cafeteria plan to permit a run-out period longer than 90 days for all participants (the run-out period must be consistent for all). That is very unusual, and it would need to be coordinated with the TPA, but it could be done.
However, keep in mind that Section 125 requires that all plan amendments be prospective in effect only. This means that any amendment to the plan’s run-out period could not affect the current situation (it would only apply going forward for future plan years).
- No Additional Tax Liability
Lastly, an employee who fails to timely submit claims for the full balance of contributions to a dependent care FSA does not take a double hit. In other words, the IRS does not require that the employee pay taxes on the unused balance as well as forfeit it. The IRS Form 2441 has a process in place to reflect this.
While employers are permitted to amend the plan’s run-out period, the Section 125 rules permit this only on a prospective basis. Furthermore, employers are not permitted to make exceptions to the plan’s run-out period deadline because the Section 125 rules require the run-out period to be identical for all employees.
In short, there is no option to amend the plan or make an exception for employees who missed submitting claims by the end of the run-out period. Engaging in either practice runs the risk of the IRS disqualifying the entire Section 125 cafeteria plan, resulting in all employee FSA and health and welfare plan pre-tax contributions being recharacterized as taxable.
There may be particularly unfortunate situations involving large dependent care FSA forfeitures or claims submitted only slightly after the end of the run-out period. However, a small number of employees forfeiting contributions is by far the better approach than risking the tax-advantaged status of the cafeteria plan for all employees. The potential consequences under Section 125 are too severe to make offering an exception a viable alternative.
I’ve copied the relevant cites below for reference.
Prop. Treas. Reg. §1.125-5(c):
(c) Use-or-lose rule.
(1) In general. An FSA may not defer compensation. No contribution or benefit from an FSA may be carried over to any subsequent plan year or period of coverage. See paragraph (k)(3) in this section for specific exceptions. Unused benefits or contributions remaining at the end of the plan year (or at the end of a grace period, if applicable) are forfeited.
Prop. Treas. Reg. §1.125-1(c)(7):
(7) Operational failure.
(i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees’ elections between taxable and nontaxable benefits result in gross income to the employees.
(ii) Failure to operate according to written cafeteria plan or section 125. Examples of failures resulting in section 125 not applying to a plan include the following—
(A) Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;
(B) Offering benefits other than permitted taxable benefits and qualified benefits;
(C) Operating to defer compensation (except as permitted in paragraph (o) of this section);
(D) Failing to comply with the uniform coverage rule in paragraph (d) in §1.125-5;
(E) Failing to comply with the use-or-lose rule in paragraph (c) in §1.125-5;
(F) Allowing employees to revoke elections or make new elections, except as provided in §1.125-4 and paragraph (a) in §1.125-2;
(G) Failing to comply with the substantiation requirements of § 1.125-6;
(H) Paying or reimbursing expenses in an FSA other than expenses expressly permitted in paragraph (h) in §1.125-5;
(I) Allocating experience gains other than as expressly permitted in paragraph (o) in §1.125-5;
(J) Failing to comply with the grace period rules in paragraph (e) of this section; or
(K) Failing to comply with the qualified HSA distribution rules in paragraph (n) in §1.125-5.
Prop. Treas. Reg. §1.125-1(f):
(f) Run-out period. A cafeteria plan is permitted to contain a run-out period as designated by the employer. A run-out period is a period after the end of the plan year (or grace period) during which a participant can submit a claim for reimbursement for a qualified benefit incurred during the plan year (or grace period). Thus, a plan is also permitted to provide a deadline on or after the end of the plan year (or grace period) for submitting a claim for reimbursement for the plan year. Any run-out period must be provided on a uniform and consistent basis with respect to all participants.
Prop. Treas. Reg. §1.125-5(o):
(o) FSA experience gains or forfeitures.
(1) Experience gains in general. An FSA experience gain (sometimes referred to as forfeitures in the use-or-lose rule in paragraph (c) in this section) with respect to a plan year (plus any grace period following the end of a plan year described in paragraph (e) in §1.125-1), equals the amount of the employer contributions, including salary reduction contributions, and after-tax employee contributions to the FSA minus the FSA’s total claims reimbursements for the year. Experience gains (or forfeitures) may be—
(i) Retained by the employer maintaining the cafeteria plan; or
(ii) If not retained by the employer, may be used only in one or more of the following ways—
(A) To reduce required salary reduction amounts for the immediately following plan year, on a reasonable and uniform basis, as described in paragraph (o)(2) of this section;
(B) Returned to the employees on a reasonable and uniform basis, as described in paragraph (o)(2) of this section; or
(C) To defray expenses to administer the cafeteria plan.
(2) Allocating experience gains among employees on reasonable and uniform basis. If not retained by the employer or used to defray expenses of administering the plan, the experience gains must be allocated among employees on a reasonable and uniform basis. It is permissible to allocate these amounts based on the different coverage levels of employees under the FSA. Experience gains allocated in compliance with this paragraph (o) are not a deferral of the receipt of compensation. However, in no case may the experience gains be allocated among employees based (directly or indirectly) on their individual claims experience. Experience gains may not be used as contributions directly or indirectly to any deferred compensation benefit plan.
Prop. Treas. Reg. §1.125-1(c)(5):
(5) Amendments to cafeteria plan. Any amendment to the cafeteria plan must be in writing. A cafeteria plan is permitted to be amended at any time during a plan year. However, the amendment is only permitted to be effective for periods after the later of the adoption date or effective date of the amendment. For an amendment adding a new benefit, the cafeteria plan must pay or reimburse only those expenses for new benefits incurred after the later of the amendment’s adoption date or effective date.
IRS Form 2441 Instructions:
If you had an employer-provided dependent care plan, enter on line 14 the total of the following amounts included on line 12.
- Any amount you forfeited. You forfeited an amount if you didn’t receive it because you didn’t incur the expense. Don’t include amounts you expect to receive at a future date.
- Any amount you didn’t receive but are permitted by your employer to carry forward and use in the following year during a grace period.
Example. Under your employer’s dependent care plan, you chose to have your employer set aside $5,000 to cover your 2017 dependent care expenses. The $5,000 is shown on your Form W-2, in box 10. In 2017, you incurred and were reimbursed for $4,950 of qualified expenses. You would enter $5,000 on line 12 and $50, the amount forfeited, on line 14. You would also enter $50 on line 14 if, instead of forfeiting the amount, your employer permitted you to carry the $50 forward to use during the grace period in 2018.
Disclaimer: The intent of this analysis is to provide the recipient with general information regarding the status of, and/or potential concerns related to, the recipient’s current employee benefits issues. This analysis does not necessarily fully address the recipient’s specific issue, and it should not be construed as, nor is it intended to provide, legal advice. Furthermore, this message does not establish an attorney-client relationship. Questions regarding specific issues should be addressed to the person(s) who provide legal advice to the recipient regarding employee benefits issues (e.g., the recipient’s general counsel or an attorney hired by the recipient who specializes in employee benefits law).