The IRS has issued guidance on two issues affecting health flexible spending arrangements (health FSAs). The first provides guidance on how a health FSA that consists solely of amounts carried forward from the prior year (through rules issued last fall that allow up to $500 to be carried forward) may be coordinated with coverage under a health savings account (HSA). The second addresses correction procedures for improper health FSA payments.

In Memorandum 201413005, the IRS confirms that an employee may not contribute to an HSA if he or she is covered under a general purpose health FSA, even if that FSA contains only amounts that are carried forward from the prior year. Individuals are generally prohibited from contributing to an HSA unless they participate in a high deductible health plan and do not participate in any other health plan that provides coverage for deductibles, copayments, and other expenses that are covered under the high deductible health plan. A general purpose health FSA would cover those expenses.

The memorandum describes a few options that employers may pursue if they have added carry forward provisions to their health FSAs and are concerned about the limits this might impose on an employee who wishes to enroll in a high deductible health plan with an HSA in the following year. These options include:

• Providing for the carry forward to be applied to a limited purpose health FSA that is compatible with an HSA
• Allowing employees to elect not to carry forward any unused amounts from their health FSA if they are going to enroll in an HSA

Memorandum 201413006 provides that employers may correct improper health FSA payments by using the same methods that apply under guidance for unsubstantiated payments when a health FSA uses a debit card. The details of this guidance, included in proposed regulation 1.125-6(d), are highlighted here. These correction mechanisms include:

• Demanding payment
• Withholding amounts from the employee's pay, to the extent permitted under applicable law
• Offsetting the amount owed by the employee against other health FSA payments

The guidance makes it clear that an employer may apply these remedies in any order as long as it follows that order consistently. The employer should seek to recover the overpayment in the same year it is made. If the employer tries all of the methods for recovery and still does not successfully recover all of the improper payments, the employer may treat the amount as business indebtedness and report it as taxable income to the employee on a Form W-2.