CLIENT ALERT: Internal Revenue Service Announces Modification of “Use It or Lose It” Rule
Many employers, as part of their Internal Revenue Code (“Code”) Section 125 cafeteria plans, reimburse employees for unreimbursed medical expenses. The Code prohibits cafeteria plans from providing for deferred compensation, and the Internal Revenue Service (“IRS”) has interpreted that rule to mean (with very limited exceptions) that contributions in one year cannot be used to purchase benefits in a subsequent plan year — commonly known as the “use it or lose it” rule. In 2005, the IRS modified this rule slightly by providing for grace periods, which permits an employee to use amounts remaining from the previous year to pay for expenses incurred during the first 2½ months following the end of the plan year.
In IRS Notice 2013-71 the IRS provided flexibility by permitting the use of up to $500 (an employer may select a lower amount) in unused amounts to be carried over to the subsequent plan year. Unlike the grace period, the $500 carryover may be used to pay or reimburse medical expenses at any time during the immediately following plan year. (The advantage of the grace period is that there is no dollar ceiling on the amount that can be used during the 2½ month grace period.) From a plan sponsor perspective, the decision to permit the $500 carryover must be made on a plan-wide basis, rather than an employee-by-employee basis. The carryover does not reduce the employee’s salary reduction amount for the year to which the unused amounts are carried over. If an employer implemented the carryover from 2013 and the employee had at least $500 as an unused amount, the employee could have $3,000 available to pay medical expenses in 2014. Any unused amount in excess of $500 (or a lower amount specified in the plan), as well as any unused amounts upon termination of employment, must be forfeited, unless the employee elects COBRA coverage with respect to his or her health flexible spending account (“FSA”).
Use of the carryover has no effect on the FSA’s run-out practices. The carryover amount may be used (i) for expenses incurred in the prior plan year, but only if claimed during the plan’s run-out period beginning at the end of the prior plan year, and (ii) for expenses that are incurred at any time during the current plan year. Salary reduction amounts (or flex credits, if available) credited for the current plan year can only be used for expenses incurred in the current year (unless they can be carried over to the next succeeding year).
In order to permit the use of the $500 carryover, a plan must generally be amended on or before the last day of the year from which amounts may be carried over, retroactive to the first day of the plan year, provided that the plan is operated in accordance with IRS guidance and participants are notified of the carryover provision. However, for carryovers from 2013 to 2014, the amendment need not be made until the end of 2014. If the plan provides for a grace period, that must also be eliminated by plan amendment (without any grace period) and before the last day of the year in which accounts may be carried over, although the IRS cautions that “the ability to eliminate a grace period provision previously adopted for the plan year in which the amendment is adopted may be subject to non-Code legal restraints,” presumably ERISA and state contract law. Therefore, employers wishing to implement a carryover option from 2013 into 2014 and whose plans currently provide for a grace period should at a minimum take action to eliminate the grace period by year end and advise employees of the change so that employees may have the opportunity to plan accordingly with respect to their incurrence of medical expenses.
For more information regarding the IRS’s modification of the “use it or lose it” rule, please contact the Olshan attorney with whom you regularly work or either of the attorneys listed below.