[authors: Dipa N. Sudra and Elizabeth J. Deckman]

In Notice 2012-40, the Internal Revenue Service (“IRS”) confirms that the $2,500 limit on salary reduction contributions to health flexible spending arrangements (“health FSAs”) does not apply for plan years beginning before 2013. This provides welcome relief to non-calendar year cafeteria plans—see the discussion in our previous advisory.

In addition, Notice 2012-40 provides additional guidance on the $2,500 limit, sets a deadline for cafeteria plan amendments, and provides relief for certain contributions mistakenly exceeding the $2,500 limit that are timely corrected.

$2,500 limit applies to plan years beginning on or after Jan. 1, 2013
Under Code Section 125(i), effective for “taxable years” beginning after Dec. 31, 2012, a health FSA is not a qualified benefit unless the cafeteria plan provides that an employee may not elect, for any taxable year, salary reduction contributions in excess of $2,500, as indexed. (Note: employer flex credits for qualified benefits do not count towards the $2,500 limit, and the limit would not apply to a stand-alone medical expense reimbursement program, funded solely by the employer).

The Notice provides that the $2,500 limit applies on a plan year basis and is first effective for plan years beginning on or after Jan. 1, 2013.

The IRS explained that since employees make salary reduction contribution elections for health FSAs only on a plan year basis, “taxable year” in Section 125(i) refers to the cafeteria plan’s plan year, and not the employee’s taxable year. This neatly resolves issues that would arise if health FSAs were to be administered on a calendar year basis. (See our previous advisory for a discussion of these issues and potential “fixes,” which are now unnecessary.)

Cafeteria plan amendments
Cafeteria plans must be amended to comply with the $2,500 limit by Dec. 31, 2014.

In addition, cafeteria plans must comply in operation with the limit and other guidance in Notice 2012-40 for all plan years beginning on or after Jan. 1, 2013. Plans that fail to do so will lose their tax qualified status, resulting in taxation of all benefits (although limited relief is available, as described below).

Changing to a short plan year
Cafeteria plans with short plan years (i.e. fewer than 12 months) after 2012 must prorate the $2,500 limit based on the number of months in the short plan year.

A plan year may be changed from a calendar year to a fiscal year for a valid business purpose. However, if the principal purpose for the change is to delay the application of the $2,500 limit, the change is not for a valid business purpose, and the plan year remains the prior plan year.

$2,500 limit applies on employee-by-employee basis
The $2,500 limit applies on an employee-by-employee basis per controlled group employer. Therefore, if only one spouse is employed, $2,500 is the limit regardless of how many dependents are potentially covered by the health FSA. However, if both spouses are employed, each may elect salary reduction contributions to an FSA, up to $2,500, even if both participate in the same health FSA sponsored by the same employer.

Application of limit to controlled groups/affiliated service groups
Employers in the same controlled group or affiliated service group are treated as a single employer for the $2,500 limit. Therefore, salary reduction contributions of employees participating in multiple cafeteria plans maintained by members of such groups must be limited to $2,500. In contrast, an employee employed by two or more employers that are not members of the same controlled group may elect up to $2,500 under each employer’s health FSA.

Application of $2,500 limit to grace periods
If a plan has a grace period, unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period will not count against the $2,500 limit for the next plan year.

Relief for reasonable mistake
If an employee erroneously elects a salary reduction of more than $2,500 for a plan year, the plan will not lose its status as a tax qualified cafeteria plan if:

• The plan is amended to comply with the $2,500 limit by Dec. 31, 2014;
• The terms of the plan apply uniformly to all participants;
• The error results from a reasonable mistake by the employer and not because of willful neglect; and
• Salary reduction contributions exceeding $2,500 are paid to the employee and reported as wages for income tax withholding and employment tax purposes on Form W-2 (or W-2c) for the employee’s taxable year in which, or with which, the cafeteria plan year of correction ends.

The relief is not available if the employer’s tax return is under examination for failure to comply with the $2,500 limit.

If you have any questions or would like to discuss plan amendments, please call any member of the Davis Wright Tremaine Employee Benefits group.