IRS Notice 2005-42
Background. Many churches have adopted flexible spending arrangements (FSAs, or “flex plans”) as a way to allow employees to pay for medical expenses with “before tax” salary reductions. The law specifies that any salary reductions not used to pay for medical expenses by December 31 are forfeited. This rule is often referred to as the “use it or lose it” rule. It’s a real hardship for many employees, and some members of Congress have been pressuring the IRS to relax this rule. In May, the IRS agreed to do so. In a published notice, the IRS stated:
A cafeteria plan document may, at the employer’s option, be amended to provide for a grace period immediately following the end of each plan year. The grace period must apply to all participants in the cafeteria plan. 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. The grace period must not extend beyond the fifteenth day of the third calendar month after the end of the immediately preceding plan year to which it relates (i.e., “the 2 and 1/2 month rule”). If a cafeteria plan document is amended to include a grace period, a participant who has unused benefits or contributions relating to a particular qualified benefit from the immediately preceding plan year, and who incurs expenses for that same qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that the participant may have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are “forfeited” under the “use-it-or-lose-it” rule.
A word of caution. The IRS cautioned that during the grace period a cafeteria plan may not permit unused contributions to be cashed-out or converted to any other taxable or nontaxable benefit. Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit. For example, unused amounts elected to pay or reimburse medical expenses in a health flexible spending arrangement (FSA) may not be used to pay or reimburse dependent care or other expenses incurred during the grace period.
Examples. The following examples illustrate the new rule.
Example. An employer with a flex plan year ending on December 31, 2005, amended the plan document before the end of the plan year to permit a grace period which allows all employees to apply unused contributions remaining at the end of the plan year to medical expenses incurred during the grace period immediately following that plan year. The grace period adopted by the employer ends on the fifteenth day of the third calendar month after the end of the plan year (March 15, 2006 for the plan year ending December 31, 2005). Employee X timely elected salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2005. As of December 31, 2005, X has $200 remaining unused in his health FSA. X timely elected salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2006. During the grace period from January 1 through March 15, 2006, X incurs $300 of unreimbursed medical expenses. The unused $200 from the plan year ending December 31, 2005 is applied to pay or reimburse $200 of X’s $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for the plan year ending December 31, 2005. The remaining $100 of medical expenses incurred between January 1 and March 15, 2006 is paid or reimbursed from X’s health FSA for the plan year ending December 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2006.
Example. Same facts as the previous example, except that X incurs $150 of medical expenses during the grace period (January 1 through March 15, 2006). As of March 16, 2006, X has $50 of unused benefits or contributions remaining for the plan year ending December 31, 2005. The unused $50 cannot be cashed-out, converted to any other taxable or nontaxable benefit, or used in any other plan year (including the plan year ending December 31, 2006). The unused $50 is subject to the “use-it-or-lose-it” rule and is “forfeited.” As of March 16, 2006, X has the entire $1,500 elected in the health FSA for the plan year ending December 31, 2006.
This article first appeared in Church Treasurer Alert, August 2005.
