Cafeteria Plans

March 13, 2024

3502 / What benefits may be offered under a cafeteria plan?

<div class="Section1">Participants in a cafeteria plan may choose among two or more benefits consisting of cash and qualified benefits.<a href="#_ftn1" name="_ftnref1">1</a> A cash benefit includes not only cash, but a benefit that may be purchased with after-tax dollars or the value of which is generally treated as taxable compensation to the employee (provided the benefit does not defer receipt of compensation).<a href="#_ftn2" name="_ftnref2">2</a><div class="Section1"> A qualified benefit is a benefit that is not includable in the gross income of the employee because of an express statutory exclusion ahnd that does not defer receipt of compensation. Contributions to Archer Medical Savings Accounts ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="422">422</a>), qualified scholarships, educational assistance programs, or excludable fringe benefits are not qualified benefits. No product that is advertised, marketed, or offered as long-term care insurance is a qualified benefit.<a href="#_ftn3" name="_ftnref3">3</a> With respect to insurance benefits, such as those provided under accident and health plans and group term life insurance plans, the benefit is the coverage under the plan. Accident and health benefits are qualified benefits to the extent that coverage is excludable under IRC Section 106.<a href="#_ftn4" name="_ftnref4">4</a> Accidental death coverage offered in a cafeteria plan under an individual accident insurance policy is excludable from the employee’s income under IRC Section 106.<a href="#_ftn5" name="_ftnref5">5</a> A cafeteria plan can offer group term life insurance coverage on employees participating in the plan. Coverage that is includable in income only because it exceeds the $50,000 excludable limit under IRC Section 79 also may be offered in a cafeteria plan.<a href="#_ftn6" name="_ftnref6">6</a> The application of IRC Section 79 to group term life insurance and IRC Section 106 to accident or health benefits is explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="240">240</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="249">249</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8789">8789</a>. Accident and health coverage, group term life insurance coverage, and benefits under a dependent care assistance program remain “qualified” even if they must be included in income because a nondiscrimination requirement has been violated.<a href="#_ftn7" name="_ftnref7">7</a> (See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3625">3625</a>.) Health coverage and dependent care assistance under flexible spending arrangements (FSAs) are qualified benefits if they meet the requirements explained in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3515">3515</a>. For taxable years beginning after December 31, 2012, a health FSA offered through a cafeteria plan will not be treated as a qualified benefit unless the plan provides that an employee may not elect for any taxable year to have salary reduction contributions in excess of $3,300 in 2025 ($3,200 in 2024, $3,050 in 2023, $2,850 in 2022 and $2,750 in 2020 and 2021) made to such arrangement.<a href="#_ftn8" name="_ftnref8">8</a> A cafeteria plan generally cannot provide for deferred compensation, permit participants to carry over unused benefits or contributions from one plan year to another, or permit participants to purchase a benefit that will be provided in a subsequent plan year. A cafeteria plan, however, may permit a participant in a profit sharing, stock bonus, or rural cooperative plan that has a qualified cash or deferred arrangement to elect to have the employer contribute on the employee’s behalf to the plan.<a href="#_ftn9" name="_ftnref9">9</a> After-tax employee contributions to a qualified plan subject to IRC Section 401(m) are permissible under a cafeteria plan, even if matching contributions are made by the employer.<a href="#_ftn10" name="_ftnref10">10</a> FSAs may allow a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement.<a href="#_ftn11" name="_ftnref11">11</a> FSAs may now be amended so that $500 of unused amounts ($660 in 2025, $640 in 2024, $610 in 2023, $570 in 2022 and $550 in 2021) remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carry forward provision may not also offer the 2½ month grace period.<a href="#_ftn12" name="_ftnref12">12</a> A cafeteria plan also may permit a participant to elect to have the employer contribute to a health savings account (HSA) on the participant’s behalf ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="390">390</a>).<a href="#_ftn13" name="_ftnref13">13</a> Unused balances in HSAs funded through a cafeteria plan may be carried over from one plan year to another. Under the general rule, life, health, disability, or long-term care insurance with an investment feature, such as whole life insurance, or an arrangement that reimburses premium payments for other accident or health coverage extending beyond the end of the plan year cannot be purchased.<a href="#_ftn14" name="_ftnref14">14</a> Supplemental health insurance policies that provide coverage for cancer and other specific diseases do not result in the deferral of compensation and are properly considered accident and health benefits under IRC Section 106.<a href="#_ftn15" name="_ftnref15">15</a> A cafeteria plan maintained by an educational organization described in IRC Section 170(b)(1)(A)(ii) (i.e., one with a regular curriculum and an on-site faculty and student body) can allow participants to elect postretirement term life insurance coverage. The postretirement life insurance coverage must be fully paid up on retirement and must not have a cash surrender value at any time. Postretirement life insurance coverage meeting these conditions will be treated as group term life insurance under IRC Section 79.<a href="#_ftn16" name="_ftnref16">16</a> To provide tax favored benefits to highly compensated employees and “key employees,” a cafeteria plan must meet certain nondiscrimination requirements and avoid concentration of benefits in key employees ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3504">3504</a>). The Affordable Care Act requires plans and issuers that offer dependent coverage to make the coverage available until a child reaches the age of 26.<a href="#_ftn17" name="_ftnref17">17</a> To implement the expanded coverage, the ACA allows employers with cafeteria plans to permit employees to immediately make pre-tax salary reduction contributions to provide coverage for children under age 27, even if the cafeteria plan has not yet been amended to cover these individuals. Both married and unmarried children qualify for this coverage. This rule applies to all plans in the individual market and to new employer plans. It also applies to existing employer plans unless the adult child has another offer of employer-based coverage. Beginning in 2014, children up to age 26 can stay on their parent’s employer plan even if they have another offer of coverage through an employer. Employees are eligible for this tax benefit from March 30, 2010 forward if the children are already covered under the employer’s plan or are added to the employer’s plan at any time. For this purpose, a child includes a son, daughter, stepchild, adopted child, or eligible foster child. This “up to age 26” standard replaces the lower age limits that applied under prior tax law, as well as the requirement that a child generally qualify as a dependent for tax purposes. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       IRC § 125(d)(1)(B). <a href="#_ftnref2" name="_ftn2">2</a>.       Prop. Treas. Reg. § 1.125-1(a)(2). <a href="#_ftnref3" name="_ftn3">3</a>.       IRC § 125(f); Prop. Treas. Reg. § 1.125-1(q). <a href="#_ftnref4" name="_ftn4">4</a>.       Prop. Treas. Reg. § 1.125-1(h)(2). <a href="#_ftnref5" name="_ftn5">5</a>.       Let. Ruls. 8801015, 8922048. <a href="#_ftnref6" name="_ftn6">6</a>.       Prop. Treas. Reg. § 1.125-1(k). <a href="#_ftnref7" name="_ftn7">7</a>.       IRC § 129(d); Prop. Treas. Reg. § 1.125-1(b)(2). <a href="#_ftnref8" name="_ftn8">8</a>.       IRC § 125(i); Rev. Proc. 2019-44, Rev. Proc. 2020-45, Rev. Proc. 2021-45, Rev. Proc. 2022-38, Rev. Proc. 2023-34, Rev. Proc. 2024-40. <a href="#_ftnref9" name="_ftn9">9</a>.       IRC § 125(d)(2). <a href="#_ftnref10" name="_ftn10">10</a>.     Prop. Treas. Reg. § 1.125-1(o)(3)(ii). <a href="#_ftnref11" name="_ftn11">11</a>.     Prop. Treas. Reg. § 1.125-1(e); Notice 2005-42, 2005-1 CB 1204. <a href="#_ftnref12" name="_ftn12">12</a>.     Notice 2013-71, 2013-47 IRB 532. <a href="#_ftnref13" name="_ftn13">13</a>.     IRC § 125(d)(2)(D). <a href="#_ftnref14" name="_ftn14">14</a>.     Prop. Treas. Reg. § 1.125-1(p)(1)(ii). <a href="#_ftnref15" name="_ftn15">15</a>.     TAM 199936046. <a href="#_ftnref16" name="_ftn16">16</a>.     IRC § 125(d)(2)(C). <a href="#_ftnref17" name="_ftn17">17</a>.     IRC § 105(b); Notice 2010-38. </div></div>

March 13, 2024

3506 / When can benefit elections under a cafeteria plan be changed?

<div class="Section1">Editor’s Note: IRS Notice 2022-41 changed the rules governing mid-year election changes and cafeteria plans in light of the final regulations that fixed the so-called “family glitch” under the ACA.   Typically, employees are not permitted to change the family coverage election mid-year.  Beginning January 1, 2023, however, a non-calendar year cafeteria plan may allow an employee to revoke an election for family coverage so that family members can enroll in ACA marketplace coverage if both of the following are true: (1) one or more of the employee’s family members are eligible to enroll in marketplace coverage during a special enrollment period or during Marketplace annual open enrollment, and (2) revoking the employee’s family coverage election corresponds with the intended enrollment of the family member in a marketplace plan.<div class="Section1"> The IRS provided relief to permit certain mid-year election changes in the wake of the COVID-19 pandemic. For mid-year elections made during calendar year 2020 or 2021, a Section 125 cafeteria plan could permit employees who are eligible to make salary reduction contributions under the plan to: <blockquote>(1)     with respect to employer-sponsored health coverage, (a) make a new election on a prospective basis, if the employee initially declined to elect employer-sponsored health coverage; (b) revoke an existing election and make a new election to enroll in different health coverage sponsored by the same employer on a prospective basis; and (c) revoke an existing election on a prospective basis, provided that the employee confirms in writing that the employee is enrolled, or immediately will enroll, in other health coverage not sponsored by the employer; and (2)     revoke an election, make a new election, or decrease or increase an existing election applicable to a health FSA or dependent care assistance program on a prospective basis.</blockquote> If an employee had unused amounts remaining in a health FSA or a dependent care assistance program under the cafeteria plan at the end of a grace period or plan year ending in 2020 or 2021, the cafeteria plan could permit employees to apply those unused amounts to pay or reimburse medical care expenses or dependent care expenses incurred through 2021 or 2022, as applicable.<a href="#_ftn1" name="_ftnref1">1</a> This relief was optional for employers.<a href="#_ftn2" name="_ftnref2">2</a> Typically, there are only certain instances when a cafeteria plan may permit an employee to revoke an election during a period of coverage and to make a new election relating to a qualified benefits plan.<a href="#_ftn3" name="_ftnref3">3</a> A cafeteria plan may permit an employee to revoke an election for coverage under a group health plan during a period of coverage and make a new election that corresponds with the special enrollment rights of IRC Section 9801(f). (This section deals generally with special enrollment periods for persons losing other group health plan coverage and dependent beneficiaries.)<a href="#_ftn4" name="_ftnref4">4</a> An election change with respect to the Section 9801(f) enrollment rights can be funded through salary reduction under a cafeteria plan only on a prospective basis, except for the retroactive enrollment right under Section 9801(f) that applies in the case of elections made within 30 days of a birth, adoption, or placement for adoption.<a href="#_ftn5" name="_ftnref5">5</a> Certain changes are permitted with respect to a judgment, decree, or order resulting from a divorce, legal separation, annulment, or change in legal custody (including a qualified medical child support order) that requires accident or health coverage for an employee’s child or for a foster child who is a dependent of the employee. A cafeteria plan may change the employee’s election to provide coverage for the child if an order requires coverage for the child under the employer’s plan. Also, the plan may permit the employee to make an election change to cancel coverage for the child if an order requires the spouse, former spouse, or other individual to provide coverage for the child and that coverage actually is provided.<a href="#_ftn6" name="_ftnref6">6</a> Additionally, if an employee, spouse, or dependent who is enrolled in the employer’s accident or health plan becomes entitled to coverage (i.e., becomes enrolled) under Medicaid or Part A or Part B of Medicare, the plan may permit the employee to make a prospective election change to reduce or cancel coverage of that employee, spouse, or dependent under the accident or health plan. Note that this does not apply to coverage consisting solely of benefits under the Social Security Act Section 1928 program for distribution of pediatric vaccines. If an employee, spouse, or dependent that has been entitled to Medicaid or Medicare Part A or Part B coverage loses eligibility for the coverage, the plan may allow the employee to make a prospective election to commence or increase coverage of that employee, spouse, or dependent under the accident or health plan.<a href="#_ftn7" name="_ftnref7">7</a> An employee taking a leave under the Family and Medical Leave Act (FMLA) may revoke an existing election of accident or health plan coverage and make such election as provided for under the FMLA for the remaining portion of the period of coverage ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3509">3509</a>).<a href="#_ftn8" name="_ftnref8">8</a> Regarding contributions under a qualified cash or deferred arrangement, the regulations state that these provisions do not apply to elective contributions under such an arrangement, within the meaning of IRC Section 401(k), or employee contributions subject to IRC Section 401(m). Therefore, a cafeteria plan may allow an employee to modify or revoke elections as provided by these sections and applicable regulations.<a href="#_ftn9" name="_ftnref9">9</a> If a cafeteria plan offers salary reduction contributions to health savings accounts (HSAs), the plan must allow participants to prospectively change or revoke salary reduction elections for HSA contributions on a monthly, or more frequent, basis.<a href="#_ftn10" name="_ftnref10">10</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       Notice 2020-29. <a href="#_ftnref2" name="_ftn2">2</a>.       Notice 2021-15. <a href="#_ftnref3" name="_ftn3">3</a>.       Treas. Reg. § 1.125-4(a). <a href="#_ftnref4" name="_ftn4">4</a>.       Treas. Reg. § 1.125-4(b). <a href="#_ftnref5" name="_ftn5">5</a>.       Treas. Reg. § 1.125-4(b)(2). <a href="#_ftnref6" name="_ftn6">6</a>.       Treas. Reg. § 1.125-4(d). <a href="#_ftnref7" name="_ftn7">7</a>.       Treas. Reg. § 1.125-4(e). <a href="#_ftnref8" name="_ftn8">8</a>.       Treas. Reg. § 1.125-4(g). <a href="#_ftnref9" name="_ftn9">9</a>.       Treas. Reg. § 1.125-4(h). <a href="#_ftnref10" name="_ftn10">10</a>.     Prop. Treas. Reg. § 1.125-2(c). </div></div>

March 13, 2024

3501 / What is a cafeteria plan?

<div class="Section1">A cafeteria plan (or “flexible benefit plan”) is a written plan in which all participants are employees who may choose among two or more benefits consisting of cash and “qualified benefits.” With certain limited exceptions, a cafeteria plan cannot provide for deferred compensation. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3502">3502</a>.<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> Some cafeteria plans provide for salary reduction contributions by the employee and others provide benefits in addition to salary. In either case, the effect is to permit participants to purchase certain benefits with pre-tax dollars. A plan may provide for automatic enrollment whereby an employee’s salary is reduced to pay for “qualified benefits” unless the employee affirmatively elects cash.<a href="#_ftn2" name="_ftnref2">2</a> Under the 2007 proposed regulations (effective for plan years beginning on or after January 1, 2009), the written plan document must contain the following: (1) a specific description of the benefits, including periods of coverage; (2) the rules regarding eligibility for participation; (3) the procedures governing elections; (4) the manner in which employer contributions are to be made, such as by salary reduction or nonelective employer contributions; (5) the plan year; (6) the maximum amount of employer contributions available to any employee stated as (a) a maximum dollar amount or maximum percentage of compensation or (b) the method for determining the maximum amount or percentage; (7) a description of whether the plan offers paid time off, and the required ordering rules for use of nonelective and elective paid time off; (8) the plan’s provisions related to any flexible spending arrangements (FSAs) included in the plan; (9) the plan’s provisions related to any grace period offered under the plan; and (10) the rules governing distributions from a health FSA to employee health savings accounts (HSAs), if the plan permits such distributions.<a href="#_ftn3" name="_ftnref3">3</a> The plan document need not be self-contained, but may incorporate by reference separate written plans.<a href="#_ftn4" name="_ftnref4">4</a> Note that under the ACA<a href="#_ftn5" name="_ftnref5">5</a>, the cost of an over-the-counter medicine or drug could not be reimbursed from FSAs or health reimbursement arrangements (HRAs) unless a prescription was obtained prior to 2020 (the CAREs Act permanently eliminated the prescription rule). The ACA rule did not affect insulin or other health care expenses such as medical devices, eyeglasses, contact lenses, co-pays and deductibles. The IRS advises employers and employees to take these changes into account as they make health benefit decisions.<a href="#_ftn6" name="_ftnref6">6</a> FSA and HRA participants may continue using debit cards to buy prescribed over-the-counter medicines, if requirements are met.<a href="#_ftn7" name="_ftnref7">7</a> In addition, starting in 2013, there were new rules about the amount that can be contributed to an FSA. For instance, a cafeteria plan may not allow an employee to request salary reduction contributions for a health FSA in excess of $3,300 for 2025 (projected) (the amount was $3,200 in 2024, $3,050 in 2023, $2,850 in 2022 and $2,750 in 2020 and 2021). A cafeteria plan offering a health FSA must be amended to specify the contribution limit (or any lower limit set by the employer). While cafeteria plans generally must be amended on a prospective basis, an amendment that was adopted on or before December 31, 2014, could be made effective retroactively, if in operation the cafeteria plan met the limit for plan years beginning after December 31, 2012. A cafeteria plan that does not limit health FSA contributions to the annual limit is not a cafeteria plan and all benefits offered under the plan are includible in the employee’s gross income. IRS Notice 2012-40 provided information about these rules (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3503">3503</a>) and flexibility for employers applying the new rules. On June 28, 2012, the Supreme Court, in National Federation of Independent Business v. Sebelius,<a href="#_ftn8" name="_ftnref8">8</a> upheld the constitutionality of the Affordable Care Act, with only minor changes to certain Medicaid provisions. While most attempts to repeal or seriously modify the ACA have failed in Congress so implementation of the ACA and its requirements continues for the time-being, the individual mandate was repealed for tax years beginning after 2018.<a href="#_ftn9" name="_ftnref9">9</a> Former employees may be participants (although the plan may not be established predominantly for their benefit), but self-employed individuals may not.<a href="#_ftn10" name="_ftnref10">10</a> A full-time life insurance salesperson who is treated as an employee for Social Security purposes will also be considered an employee for cafeteria plan purposes.<a href="#_ftn11" name="_ftnref11">11</a> </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       IRC § 125(d). <a href="#_ftnref2" name="_ftn2">2</a>.       Rev. Rul. 2002-27, 2002-1 CB 925. <a href="#_ftnref3" name="_ftn3">3</a>.       Prop. Treas. Reg. § 1.125-1(c). <a href="#_ftnref4" name="_ftn4">4</a>.       Prop. Treas. Reg. § 1.125-1(c)(4). <a href="#_ftnref5" name="_ftn5">5</a>.       P.L. 111-148. <a href="#_ftnref6" name="_ftn6">6</a>.       See IRS News Release IR-2010-95 (Sept. 3, 2010). <a href="#_ftnref7" name="_ftn7">7</a>.       IRS News Release IR-2010-128 (Dec. 23, 2010). <a href="#_ftnref8" name="_ftn8">8</a>.       567 U.S. 519 (2012). <a href="#_ftnref9" name="_ftn9">9</a>.       See, e.g., Miller, “The ACA Remains, but Targeted reforms Will be Sought’” SHRM, Jul. 24, 2017 at www.shrm.org. <a href="#_ftnref10" name="_ftn10">10</a>.     Prop. Treas. Reg. § 1.125-1(g). <a href="#_ftnref11" name="_ftn11">11</a>.     IRC § 7701(a)(20); Prop. Treas. Reg. § 1.125-1(g)(1)(iii). </div></div>

March 13, 2024

3503 / What are the income tax benefits of a cafeteria plan?

<div class="Section1">As a general rule, a participant in a cafeteria plan (as defined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3501">3501</a>), is not treated as being in constructive receipt of taxable income solely because he has the opportunity – before a cash benefit becomes available – to elect among cash and “qualified” benefits (generally, nontaxable benefits, but as defined in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3502">3502</a>).<a href="#_ftn1" name="_ftnref1">1</a><div class="Section1"> In order to avoid taxation, a participant must elect the qualified benefits before the cash benefit becomes currently available. That is, the election must be made before the specified period for which the benefit will be provided begins—generally, the plan year.<a href="#_ftn2" name="_ftnref2">2</a> A cafeteria plan may, but is not required to, provide default elections for one or more qualified benefits for new employees or for current employees who fail to timely elect between permitted taxable and qualified benefits.<a href="#_ftn3" name="_ftnref3">3</a> Note that a benefit provided under a cafeteria plan through employer contributions to a health flexible spending arrangement (FSA) is not treated as a qualified benefit unless the plan provides that an employee may not elect for any taxable year to have salary reduction contributions in excess of the annual contribution cap ($3,300 for 2025 (projected), $3,200 for 2024, $3,050 for 2023 and $2,850 for 2022, as adjusted annually for inflation) made to the FSA.<a href="#_ftn4" name="_ftnref4">4</a> Under IRS Notice 2012-40: <blockquote>(1)     the contribution limit does not apply for plan years that begin before 2013; (2)     the term “taxable year” in IRC Section 125(i) refers to the plan year of the cafeteria plan, as this is the period for which salary reduction elections are made; (3)     plans were permitted to adopt the required amendments to reflect the contribution limit at any time through the end of calendar year 2014; (4)     in the case of a plan providing a grace period (which may be up to two months and 15 days), unused salary reduction contributions to the health FSA for plan years beginning in 2012 or later that are carried over into the grace period for that plan year will not count against the contribution limit for the subsequent plan year; and (5)     unless a plan’s benefits are under examination by the IRS, relief is provided for certain salary reduction contributions exceeding the contribution limit that are due to a reasonable mistake and not willful neglect, and that are corrected by the employer.</blockquote> For the income tax effect of a discriminatory plan on highly compensated individuals, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3504">3504</a>. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 125; Prop. Treas. Reg. § 1.125-1. <a href="#_ftnref2" name="_ftn2">2</a>.     Prop. Treas. Reg. § 1.125-2. <a href="#_ftnref3" name="_ftn3">3</a>.     Prop. Treas. Reg. § 1.125-2(b). <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 125(i). </div></div>

March 13, 2024

3516 / What is a health flexible spending arrangement?

<div class="Section1">Editor’s Note: Health FSAs typically operate under a “use it or lose it rule.” As participants know, FSA amounts not used by the end of a grace period following the year-end are typically forfeited. Plans are also permitted to allow a $660 (in 2025, $640 in 2024 and $610 in 2023) per-year carryover. Late in 2020, Congress enacted the CAA, which allowed amendments to health FSAs and dependent care FSAs to permit participants to carry over any unused amounts from the 2020 plan year into the 2021 plan year. FSAs with plan years ending in 2021 were similarly permitted to allow participants to carry over all unused amounts into plan years ending in 2022. If the plan already had a grace period in place, the grace period could be extended to 12 months after the end of the plan year. Relatedly, FSAs were permitted to allow employees who stopped participating in the FSA during 2020 or 2021 to continue receiving amounts from the FSA through the end of the year in which the employee stopped participating (including any grace periods and extended grace periods).<div class="Section1"> Although health coverage under an FSA need not be provided under commercial insurance, it must demonstrate the risk shifting and risk distribution characteristics of insurance. Reimbursements under a health FSA must be paid specifically to reimburse medical expenses that have been incurred previously. A health FSA cannot operate so as to provide coverage only for periods during which the participants expect to incur medical expenses, if such period is shorter than a plan year. In addition, the maximum amount of reimbursement must be available at all times throughout the period of coverage (properly reduced for prior reimbursements for the same period of coverage), without regard to the extent to which the participant has paid the required premiums for the coverage period, and without a premium payment schedule based on the rate or amount of covered claims incurred in the coverage period.<a href="#_ftn1" name="_ftnref1">1</a> Before 2013, there was no statutory limit on contributions to a health FSA, but most employers imposed a limit to protect themselves against large claims that had not yet been funded by salary reductions. The period of coverage must be 12 months, or in the case of a short first plan year, the entire first year (or the short plan year where the plan year is changed). Election changes may not be permitted to increase or decrease coverage during a coverage year, but prospective changes may be allowed if they are consistent with certain changes in family status. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3506">3506</a>. The plan may permit the period of coverage to be terminated if the employee fails to pay premiums, provided that the terms of the plan prohibit the employee from making a new election during the remaining period of coverage. The plan may permit revocation of existing elections by an employee who terminated service.<a href="#_ftn2" name="_ftnref2">2</a> A plan may provide a grace period of no more than 2½ months following the end of the plan year for participants to incur and submit expenses for reimbursement. The grace period must apply to all participants in the plan. Plans may adopt a grace period for the current plan year by amending the plan document before the end of the current plan year.<a href="#_ftn3" name="_ftnref3">3</a> Further, beginning in 2014, health FSAs may be amended so that $500 of each participant’s unused amounts remaining at the end of the plan year may be carried forward to the next plan year. However, plans that incorporate the carryover provision may not also offer the 2½ month grace period.<a href="#_ftn4" name="_ftnref4">4</a> In 2020, the IRS clarified that the amount that may be carried forward will be inflation-adjusted, so that the amount that can be carried over to the following year from a health FSA will equal 20 percent of the maximum inflation-indexed salary reduction amount under Section 125 (increasing the carryover amount to $660 in 2025, $640 in 2024, $610 for 2023).<a href="#_ftn5" name="_ftnref5">5</a> This change, while enacted in the wake of the COVID-19 pandemic, is permanent. <hr> Planning Point: The IRS has released guidance clarifying application of the carryover provision. The IRS guidance has made clear that, unlike health savings accounts (HSAs) or health reimbursement arrangements (HRAs), the FSA cannot allow the participant to accumulate funds from year to year. The carryover applies only to the single year that immediately follows the year of contribution.<a href="#_ftn6" name="_ftnref6">6</a> <hr> The plan may reimburse medical expenses of the kind described under IRC Section 213(d), but may not reimburse for premiums paid for other health plan coverage.<a href="#_ftn7" name="_ftnref7">7</a> Editor’s Note: Under current law, the plan can reimburse for nonprescription over- the-counter drugs.<a href="#_ftn8" name="_ftnref8">8</a> However, for taxable years beginning after December 31, 2010 and before March 2020, reimbursements for medicine were limited to doctor-prescribed drugs and insulin. That requirement was repealed by the 2020 CARES Act in the wake of the COVID-19 pandemic.<a href="#_ftn9" name="_ftnref9">9</a> The medical expenses must be for medical care provided during the period of coverage with substantiation that the expense claimed has been incurred and is not reimbursable under other health coverage.<a href="#_ftn10" name="_ftnref10">10</a> <hr> Planning Point: Employees should remember that health expenses are deemed to be “incurred” when the service is actually provided--not when the employee is billed. <hr> The IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred, provided that the employer requires subsequent substantiation of the expenses or has in place sufficient procedures to substantiate the payments at the time of purchase.<a href="#_ftn11" name="_ftnref11">11</a> On a one-time basis, a plan may allow a qualified HSA distribution. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="413">413</a>. Employer-provided coverage for qualified long-term care services provided through an FSA is included in the employee’s gross income.<a href="#_ftn12" name="_ftnref12">12</a> Informal IRS Guidance on FSAs. In August of 2001, the IRS provided informal, nonbinding guidance regarding FSAs. In a departure from previous informal guidance, the IRS indicated that orthodontia expenses should be treated differently from other medical expenses. Under this reasoning, if orthodontia expenses are paid in a lump sum when treatment commences, rather than over the course of treatment, they could be reimbursed under an FSA when paid. Finally, the IRS informally clarified that there is no de minimis claim amount that need not be substantiated; employers and plan administrators may not disregard the substantiation requirements for small claims. </div><div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.       Prop. Treas. Reg. § 1.125-5(d). <a href="#_ftnref2" name="_ftn2">2</a>.       Prop. Treas. Reg. § 1.125-5(e). <a href="#_ftnref3" name="_ftn3">3</a>.       Prop. Treas. Reg. § 1.125-1(e); Notice 2005-42, 2005-1 CB 1204. <a href="#_ftnref4" name="_ftn4">4</a>.       Notice 2013-71, 2013-47 IRB 532. <a href="#_ftnref5" name="_ftn5">5</a>.       Notice 2022-55, Notice 2023-34, Notice 2024-40. <a href="#_ftnref6" name="_ftn6">6</a>.       IRS INFO 2018-0012. <a href="#_ftnref7" name="_ftn7">7</a>.       Prop. Treas. Reg. § 1.125-5(k). <a href="#_ftnref8" name="_ftn8">8</a>.       Rev. Rul. 2003-102, 2003-2 CB 559. <a href="#_ftnref9" name="_ftn9">9</a>.       IRC § 106(f), as added by ACA 2010. <a href="#_ftnref10" name="_ftn10">10</a>.     Prop. Treas. Reg. § 1.125-6(b); Rev. Proc. 2003-43, 2003-1 CB 935. See Grande v. Allison Engine Co., 2000 U.S Dist. LEXIS 12220 (S.D. Ind. 2000). <a href="#_ftnref11" name="_ftn11">11</a>.     Notice 2006-69, 2006-2 CB 107. See also Notice 2007-2, 2007-1 CB 254. <a href="#_ftnref12" name="_ftn12">12</a>.     IRC § 106(c)(1). </div></div>

June 07, 2019

3512 / What is the tax credit for employers that provides paid family and medical leave to employees?

<div class="Section1">The 2017 Tax Act created a new temporary tax credit for employers that provide paid family and medical leave to employees.<a href="#_ftn1" name="_ftnref1">1</a> The credit is an amount equal to 12.5 percent of the wages that are paid to qualifying employees during a period where the employee was on family and medical leave if the employee is paid 50 percent of the normal wages that he or she would receive from the employer. The credit increases by 0.25 percentage points (but can never exceed 25 percent) for each percentage point by which the rate of payment exceeds 50 percent of wages.</div> <div class="Section1"> For purposes of the 50 percent of wages requirement, overtime and discretionary bonuses are excluded from the wages that are normally paid. Wages paid by a third-party payor, such as an insurance company or professional employer organization, are taken into account if based on services provided by the employee to the eligible employer. Similarly, amounts paid under the employer’s short-term disability program are taken into account. The rate of pay does not have to be uniform. <blockquote>Example: The employer provides six weeks paid leave for a qualifying employee for the birth or adoption of a child, at a rate of 100 percent of wages. The same employer provides two weeks of annual leave paid at a rate of 75 percent of wages for all other FMLA purposes. The policy satisfies the paid leave requirements. Note that the rate of pay cannot vary based on the employee’s classification (i.e., the employee cannot be paid leave offered only to employees not covered by a collective bargaining agreement).<a href="#_ftn2" name="_ftnref2">2</a></blockquote> Only 12 weeks of family and medical leave can be taken into account for any one employee. Further, all part-time employees must be allowed a pro-rated amount of paid family and medical leave.<a href="#_ftn3" name="_ftnref3">3</a> Any leave paid for by the state or local government is not taken into account.<a href="#_ftn4" name="_ftnref4">4</a> In order to qualify, employers must have a written policy in place to allow all qualifying full-time employees no less than two weeks of paid family and medical leave each year. The written policy may be set forth in a single document, or in multiple documents that cover different classes of employee or different types of leave. The policy must be in place before the leave for which the employer claims the credit is taken, except as otherwise provided in a transition rule. A policy is considered to be “in place” at the later of its adoption date or effective date. Under the transition rule, the policy was considered “in place” as of its effective date, rather than a later adoption date, for the first tax year beginning after December 31, 2017 if the policy (a) was adopted before December 31, 2018 and (b) the employer complied with the terms of the policy for the entire retroactive period.<a href="#_ftn5" name="_ftnref5">5</a> The employer need not be subject to title 1 of the Family and Medical Leave Act of 1993 (FMLA) to be a qualifying employer. However, employers who employ at least one employee who is not subject to title 1 of the FMLA must include and comply with “noninterference” language in the required written policy. This language must generally state that the employer will not attempt to interfere with the employee’s exercise of his or her rights under the written policy, and will not discharge or discriminate against an employee who opposes any practice prohibited by the written policy.<a href="#_ftn6" name="_ftnref6">6</a> “Qualifying employees” are those who have been employed by the employer for one year or more and who had compensation that did not exceed 60 percent of the compensation threshold for highly compensated employees<a href="#_ftn7" name="_ftnref7">7</a> in the previous year.<a href="#_ftn8" name="_ftnref8">8</a> The employer can use any reasonable method to determine how long the employee has been employed. Further, there is no minimum hours requirement in determining how long the employee has been employed, and requiring the employee to work a minimum number of hours would not be treated as a reasonable method for determining whether an employee has been employed for one year (the requirement that an employee work at least 1,250 hours to be an FMLA-eligible employee does not apply to the Section 45S credit). If the employee is otherwise a qualifying employee, the employer’s written policy cannot exclude any class of employees (although the amount of paid leave provided may be pro-rated for part-time employees who customarily work fewer than 30 hours per week). For part-time employees, the paid leave ratio must be at least equal to the ratio of the expected weekly hours worked by a qualifying employee who is a part-time employee to the expected weekly hours worked by an equivalent qualifying employee who is not a part-time employee.<a href="#_ftn9" name="_ftnref9">9</a> <hr /> Planning Point: The employee must be a qualifying employee at the date the paid leave is taken for the credit to apply. <hr /> “Family and medical leave” means leave as defined under Section 102(a)(1)(a)-(e) or Section 102(a)(3) of the FMLA. It includes leave taken as a result of: (1) the birth of a child, (2) adoption or fostering of a child, (3) the need to care for the employee’s spouse, child or parent who has a serious health condition, (4) a serious health condition that makes the employee unable to perform his or her job, (5) issues arising due to the employee’s spouse, child or parent being on covered active duty (or being notified of an impending order to covered duty), or (6) the need to care for a service member who is the employee’s spouse, child, parent or next of kin. Paid leave that is vacation leave, personal leave or other medical or sick leave does not qualify for the Section 45S tax credit.<a href="#_ftn10" name="_ftnref10">10</a> The employer’s policy must strictly apply to only leave that qualifies as an FMLA purpose—meaning that the employer cannot give the employee a choice between an FMLA purpose and vacation leave, for example. This is the case even if the employee actually does use the leave for a qualifying purpose. The IRS has carved out an exception for situations where the employer provides leave to care for a group of individuals, and one or more of those individuals is not a qualified individual for FMLA purposes. In this case, the policy will continue to qualify, except that if an employee takes the leave to care for a non-qualified individual, the employer will not be entitled to the credit with respect to that employee.<a href="#_ftn11" name="_ftnref11">11</a> This credit is only available for tax years beginning after December 31, 2017 and before December 31, 2025 (as extended), and is a part of the general business tax credit.<a href="#_ftn12" name="_ftnref12">12</a> The credit is allowed against the alternative minimum tax (AMT). </div> <div class="refs"> <hr align="left" size="1" width="33%" /> <a href="#_ftnref1" name="_ftn1">1</a>. IRC § 45S (added by the Tax Cuts and Jobs Act). <a href="#_ftnref2" name="_ftn2">2</a>. Notice 2018-71. <a href="#_ftnref3" name="_ftn3">3</a>. IRC § 45S(c)(1). <a href="#_ftnref4" name="_ftn4">4</a>. IRC § 45S(c)(4). <a href="#_ftnref5" name="_ftn5">5</a>. Notice 2018-71. <a href="#_ftnref6" name="_ftn6">6</a>. Notice 2018-71. <a href="#_ftnref7" name="_ftn7">7</a>. Under IRC § 414(g)(1)(B). <a href="#_ftnref8" name="_ftn8">8</a>. IRC § 45S(d). <a href="#_ftnref9" name="_ftn9">9</a>. Notice 2018-71. <a href="#_ftnref10" name="_ftn10">10</a>. IRC § 45S(e). <a href="#_ftnref11" name="_ftn11">11</a>. Notice 2018-71. <a href="#_ftnref12" name="_ftn12">12</a>. IRC § 45S(a)(1). </div>