IRS Modifies 'Use-It-Or-Lose-It' Rule For Section 125 Cafeteria Plans

The Internal Revenue Service has modified the rule prohibiting deferred compensation under a Section 125 cafeteria plan to allow a grace period of up to 2.5 months after the end of the plan year to use the benefits or contributions before those amounts are forfeited under the “use-it-or-lose-it” rule. Notice 2005-42, 2005-23 I.R.B. 1 (May 18, 2005) (the Notice) permits a 2.5- month grace period during which additional expenses can be incurred and which will be reimbursed from contributions made in the plan year preceding the grace period. An employer may adopt a grace period for the current cafeteria plan year by amending the plan before the end of the current plan year.

Implications

The 2.5-month grace period relaxes the restrictive rule for health flexible spending arrangements (FSAs) and dependent care assistance programs that any funds that were not spent by the end of the plan year would be forfeited. By permitting participants to use contributions for 1 plan year to purchase a benefit that is provided during the first 2.5 months in a subsequent plan year, the new rule will ease the year-end spending rush and provide an incentive for employees to participate in health FSAs. 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. It should be noted that cafeteria plans with a June 30 plan year end must be amended by June 30, 2005, in order for the grace period to be effective for the current plan year.

Background

Section 125 and the regulations thereunder provide that a cafeteria plan does not include any plan that defers the receipt of compensation or operates in a manner that enables participants to defer compensation by, for example, permitting participants to use contributions for 1 plan year to purchase a benefit that will be provided in a subsequent plan year (commonly referred to as the “use-it-or lose-it” rule).

The Notice states that other areas of tax law provide that for a short, limited period, compensation for services paid in the year following the year in which the services are performed is not treated as deferred compensation. For example, for purposes of the deduction rules in Section 404(a), (b) and (d), under Treas. Reg. 1.404(b)-1T, Q&A-2(c), a plan is not considered a deferred compensation plan to the extent that compensation or benefits are received by the employee on or before the 15th day of the third calendar month after the end of the employer's taxable year. The Notice states that consistent with other areas of tax law, Treasury and IRS believe it is appropriate to modify the current prohibition on deferred compensation in the proposed regulations under Section 125 to permit a grace period after the end of the plan year during which unused benefits or contributions may be used.

Notice 2005-42

At the employer's option, a cafeteria plan may be amended to provide for a grace period immediately following the end of each plan year. To qualify:

• The grace period must apply to all participants in the plan;
• The grace period must not extend beyond the 15th day of the third calendar month after the end of the immediately preceding plan year to which it relates (the 2.5 month rule);
• 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 tax year;
• During the grace period, the cafeteria plan may not permit unused benefits or contributions to be cashed-out or converted to any other taxable or nontaxable benefit;
• Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that qualified benefit (eg, unused health FSA amounts cannot be used for dependent care expenses incurred during the grace period); and
• Any unused benefits or contributions from the immediately preceding plan year that exceed expenses for the qualified benefit incurred during the grace period may not be carried forwarded to any subsequent period and are forfeited under the “use-it-or-lose-it” rule.

Employers may continue to provide a “run-out” period after the end of the grace period, during which expenses for qualified benefits incurred during the cafeteria plan year and the grace period may be paid or reimbursed.

An example in the Notice illustrates how the grace period rules apply to a cafeteria plan with a plan year ending on Dec. 31, 2005, which was amended before the end of the plan year to permit a 2.5-month grace period (grace period ending March 15, 2006, for the plan year ending on Dec. 31, 2005). Employee X timely elected salary reduction of $1000 for a health FSA for the plan year ending Dec. 31, 2005. As of Dec. 31, 2005, X has $200 remaining unused in his health FSA. X timely elected salary reduction for a health FSA of $1,500 for the plan year ending Dec. 31, 2006. During the grace period from Jan. 1 through March 15, 2006, X incurs $300 of unreimbursed medical expenses (as defined in Section 213(d)). The unused $200 from the plan year ending Dec. 31, 2005 is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for the plan year ending Dec. 31, 2005. The remaining $100 of medical expenses incurred between Jan. 1 and March 15, 2006 is paid or reimbursed from X's health FSA for the plan year ending Dec. 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending Dec. 31, 2006.

Another example indicates that if X incurred only $150 of medical expenses during the grace period (when X had $200 remaining unused for the plan year ending Dec. 31, 2005), the unused $50 is subject to the “use-it-or-lose-it” rule and is forfeited.

Note that expenses incurred during the grace period will not be deductible by the employer before the expense is actually incurred, which is the tax year which includes the grace period.

The Notice states that future guidance will modify Prop. Treas. Reg. sections 1.125-1 and 1.125-2 to reflect the provisions in this Notice.

Ruth Wimer and Alice Kurt are members of Ernst & Young's Compensation and Benefits Group. They can be reached at [email protected] and [email protected], respectively.

The Internal Revenue Service has modified the rule prohibiting deferred compensation under a Section 125 cafeteria plan to allow a grace period of up to 2.5 months after the end of the plan year to use the benefits or contributions before those amounts are forfeited under the “use-it-or-lose-it” rule. Notice 2005-42, 2005-23 I.R.B. 1 (May 18, 2005) (the Notice) permits a 2.5- month grace period during which additional expenses can be incurred and which will be reimbursed from contributions made in the plan year preceding the grace period. An employer may adopt a grace period for the current cafeteria plan year by amending the plan before the end of the current plan year.

Implications

The 2.5-month grace period relaxes the restrictive rule for health flexible spending arrangements (FSAs) and dependent care assistance programs that any funds that were not spent by the end of the plan year would be forfeited. By permitting participants to use contributions for 1 plan year to purchase a benefit that is provided during the first 2.5 months in a subsequent plan year, the new rule will ease the year-end spending rush and provide an incentive for employees to participate in health FSAs. 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. It should be noted that cafeteria plans with a June 30 plan year end must be amended by June 30, 2005, in order for the grace period to be effective for the current plan year.

Background

Section 125 and the regulations thereunder provide that a cafeteria plan does not include any plan that defers the receipt of compensation or operates in a manner that enables participants to defer compensation by, for example, permitting participants to use contributions for 1 plan year to purchase a benefit that will be provided in a subsequent plan year (commonly referred to as the “use-it-or lose-it” rule).

The Notice states that other areas of tax law provide that for a short, limited period, compensation for services paid in the year following the year in which the services are performed is not treated as deferred compensation. For example, for purposes of the deduction rules in Section 404(a), (b) and (d), under Treas. Reg. 1.404(b)-1T, Q&A-2(c), a plan is not considered a deferred compensation plan to the extent that compensation or benefits are received by the employee on or before the 15th day of the third calendar month after the end of the employer's taxable year. The Notice states that consistent with other areas of tax law, Treasury and IRS believe it is appropriate to modify the current prohibition on deferred compensation in the proposed regulations under Section 125 to permit a grace period after the end of the plan year during which unused benefits or contributions may be used.

Notice 2005-42

At the employer's option, a cafeteria plan may be amended to provide for a grace period immediately following the end of each plan year. To qualify:

• The grace period must apply to all participants in the plan;
• The grace period must not extend beyond the 15th day of the third calendar month after the end of the immediately preceding plan year to which it relates (the 2.5 month rule);
• 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 tax year;
• During the grace period, the cafeteria plan may not permit unused benefits or contributions to be cashed-out or converted to any other taxable or nontaxable benefit;
• Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that qualified benefit (eg, unused health FSA amounts cannot be used for dependent care expenses incurred during the grace period); and
• Any unused benefits or contributions from the immediately preceding plan year that exceed expenses for the qualified benefit incurred during the grace period may not be carried forwarded to any subsequent period and are forfeited under the “use-it-or-lose-it” rule.

Employers may continue to provide a “run-out” period after the end of the grace period, during which expenses for qualified benefits incurred during the cafeteria plan year and the grace period may be paid or reimbursed.

An example in the Notice illustrates how the grace period rules apply to a cafeteria plan with a plan year ending on Dec. 31, 2005, which was amended before the end of the plan year to permit a 2.5-month grace period (grace period ending March 15, 2006, for the plan year ending on Dec. 31, 2005). Employee X timely elected salary reduction of $1000 for a health FSA for the plan year ending Dec. 31, 2005. As of Dec. 31, 2005, X has $200 remaining unused in his health FSA. X timely elected salary reduction for a health FSA of $1,500 for the plan year ending Dec. 31, 2006. During the grace period from Jan. 1 through March 15, 2006, X incurs $300 of unreimbursed medical expenses (as defined in Section 213(d)). The unused $200 from the plan year ending Dec. 31, 2005 is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for the plan year ending Dec. 31, 2005. The remaining $100 of medical expenses incurred between Jan. 1 and March 15, 2006 is paid or reimbursed from X's health FSA for the plan year ending Dec. 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending Dec. 31, 2006.

Another example indicates that if X incurred only $150 of medical expenses during the grace period (when X had $200 remaining unused for the plan year ending Dec. 31, 2005), the unused $50 is subject to the “use-it-or-lose-it” rule and is forfeited.

Note that expenses incurred during the grace period will not be deductible by the employer before the expense is actually incurred, which is the tax year which includes the grace period.

The Notice states that future guidance will modify Prop. Treas. Reg. sections 1.125-1 and 1.125-2 to reflect the provisions in this Notice.

Ruth Wimer and Alice Kurt are members of Ernst & Young's Compensation and Benefits Group. They can be reached at [email protected] and [email protected], respectively.