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.