Health FSAs

 

ComplianceDashboard (the “Dashboard”) contains a wealth of information regarding health Flexible Spending Arrangements (“health FSAs” or “FSAs”).  However, much of that information is found in discussions of laws and regulations that impact health FSAs along with other health plans.  This Geek Out! page consolidates that material into a single article while adding some additional information not found elsewhere on the Dashboard.

Health FSAs are impacted by a variety of federal laws and regulations (which are discussed in length at the end of this page) including:

• The Internal Revenue Code (IRC)
• ERISA
• HIPAA
• COBRA
• ACA
• FMLA

BACKGROUND

A health FSA is a type of cafeteria plan.  Broadly speaking, a cafeteria plan is one which permits employees to elect between taxable and qualified non-taxable benefits and complies with the requirements of IRC section 125.   Section 125 provides that cash (including certain taxable benefits) offered to an employee through a nondiscriminatory cafeteria plan is not includible in the employee’s gross income merely because the employee has the opportunity to choose among cash and qualified cafeteria plan benefits.  A health FSA is a qualified cafeteria plan benefit.¹  Accordingly, employees can pay for medical expenses through a health FSA with pre-tax dollars.    A health FSA is also a self-insured, employer-sponsored health plan and is subject to IRC section 105.

Typically, employers fund health FSAs with employee salary reductions; some employers also include employer contributions.  Employees determine the amount of salary reduction contributions they wish to make each year and they are not permitted to change that election during the course of the year absent special circumstances.

Generally, FSAs are “use-it-or-lose it” plans. This means that amounts unspent by the end of the plan year is forfeited. However, the plan can provide for either a 2 1/2-month grace period or a $500 roll-over from one plan year to the next.

Health FSAs are also subject to non-discrimination requirements intended to assure that the plan is not used or designed to be used primarily by highly compensated and other highly-placed employees.

Health FSAs are health plans for purposes of ERISA and those employers who are subject to ERISA need to comply to the latter’s requirements as well.

Health FSAs are health plans for purposes of the ACA and HIPAA but, properly designed, they will be considered exempt from the former’s health plan mandates and from the latter’s portability provisions. However, health FSAs are subject to HIPAA’s Privacy and Security rules.

HEALTH FSAs AS EXCEPTED BENEFITS

We begin the discussion of health FSAs with what is required for an FSA to be an excepted benefit under HIPAA.   This may seem like an odd starting point; however, much of the material that follows depends on an understanding of this concept.  In addition, regulations under the ACA have created an environment where an employer whose health FSA is not an excepted benefit is at significant risk of incurring excise taxes of up to $100/day/participant.

HIPAA created a category of benefits that are not subject to HIPAA’s non-discrimination provisions known as “excepted benefits”.  The ACA incorporated this concept by exempting excepted benefits from most of its requirements as well.

This link will take you to a discussion of excepted benefits generally.  We will focus here on the concept of excepted benefits as it applies specifically to health FSAs.

For a health FSA to be an excepted benefit it must meet two requirements.

1. Availability: First, other group health plan coverage, not limited to excepted benefits, must be made available for the year to the FSA participants.

This means that employees who are eligible to participate in the FSA must also be eligible for coverage under a plan sponsored by the employer that provides payment for medical expenses other than just dental or vision expenses.

2. Maximum Benefit: Second, the arrangement must be structured so that the maximum annual benefit payable to any participant cannot exceed two times the participant’s salary reduction election under the arrangement for the year (or, if greater, cannot exceed $500 plus the amount of the participant’s salary reduction election).  For this purpose, any amount that an employee can elect to receive as taxable income but elects to apply to the health flexible spending arrangement is considered a salary reduction election.

In practice, an FSA which does not include any employer contributions will satisfy the maximum benefit condition.

FSAs with Carry-over Provisions: Unused carry over amounts remaining at the end of a plan year in a health FSA that satisfy the modified “use-or-lose” rule (see below)  should not be taken into account when determining if the health FSA satisfies the maximum benefit payable limit.

There is a special category of health FSA known as a limited-purpose FSA.  This is an FSA which only reimburses participants for dental and vision expenses.  A limited-purpose FSA will be considered an excepted benefit, even it does not meet the two conditions described above.

DOCUMENTATION

Both the IRC and ERISA impose documentation requirements.

IRC

A health FSA must be in writing and include the following information:

• A specific description of each of the benefits available through the plan, including the periods during which the benefits are provided (the period of coverage which is always the plan year, subject to optional extensions for grace periods and benefit carry-overs – see below);
• The plan’s rules governing participation, and specifically requiring that all participants in the plan be employees;
• The procedures governing employees’ elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective, and providing that elections are irrevocable, except to the extent that the optional change in status rules are included in the cafeteria plan;
• The manner in which employer contributions may be made under the plan, (for example, through an employee’s salary reduction election or by non-elective employer contributions (that is, flex-credits), or both;
• The maximum amount of employer contributions available to any employee through the plan.
• The plan year (normally 12 consecutive months).
• The plan’s provisions complying with the uniform coverage rule and the use-or-lose rules.
• The plan’s provisions (if any) related to grace periods.
• The plan’s provisions (if any) related to benefit carry-overs.
• The plan’s provisions (if any) for distributions from a health FSA to employees’ HSAs.

ERISA

ERISA governs employer-sponsored health plans.  A health FSA is an employer-sponsored health plan.  Health FSAs sponsored by government or church employers are not subject to ERISA.

ERISA requires employers to have a written plan document that describes the benefits of the FSA.  Click here for more information on what ERISA requires plan documents to include.

Note that there is some overlap between the requirements of ERISA and those of the IRC.

In addition, employers must prepare and distribute an SPD for its health FSA.  Click here for information on what ERISA requires the SPD to include and how it must be distributed..

ACA

The ACA requires health plans to distribute a Summary of Benefits and Coverage.  In addition, self-funded FSAs may be subject to PCORI fees. These requirements generally do not apply to a health FSA if it is an excepted benefit.

PARTICIPANTS AND BENEFICIARIES

Employees:  Only employees may participate in a health FSA.  (However, see material below on COBRA elections by spouses, ex-spouses and dependents.)

The term “employee” includes:

• common law employees;
• former employees (but not if the plan is established primarily for the benefit of former employees);
• full-time life insurance salesmen who are considered statutory employees;
• leased employees.

The term “employee” does not include:

• Self-employed persons.
• Sole proprietors.
• Partners in a partnership.
• Members of boards of directors.
• More-than-2% shareholders of a subchapter S corporation.

While only employees can be participants in a cafeteria plan, the plan can reimburse expenses for medical care incurred by the employee’s spouse and dependents.

Spouses:  A spouse includes same-sex spouses if they are married.  It does not include same or opposite-sex individuals in a domestic partnership.

Dependent:  A dependent includes any person who meets the definition a qualifying child or qualifying relative under Code Section 152.  In practice, health FSAs often narrow the list of eligible dependents to an employee’s children, step-children, foster children and adopted children.  Code Section 152 imposes a variety of requirements regarding the dependent’s residence and support.  The ACA removed those requirements and a health FSA may now reimburse expenses incurred by an employee’s child, step-child, foster child or adopted child through the end of the year in which the child turns 26.  Section 152 requirements related to residency, income and support do not apply.  Analysis under section 152 is still relevant if the plan wishes to include other individuals as eligible beneficiaries.

 

DISTRIBUTIONS FROM AN FSA

The distributions from a health FSA must be paid only to reimburse an employee for qualified medical expenses said employee incurred during the period of coverage. Qualified medical expenses are those specified in the plan that generally would qualify for the medical and dental expenses deduction under IRS Section 213(d). These expenses include the amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease.

Check out our Geek Out! page for complete lists of medical and dental expenses that can and cannot be itemized ductions claimed on Schedule A of Form 1040 (Individual Income Tax Return).

Qualified medical expenses are those incurred by the following persons:

1. You and your spouse;
2. All dependents you claim on your tax return;
3. Any person you have claimed as a dependent on your return; and
4. Your child under age 27 at the end of your tax year.

You can’t receive distributions from your FSA for the following expenses:

1. Amounts paid for health insurance premiums;
2. Amounts paid for long-term care coverages or expenses; and
3. Amounts that are covered under another health plan.

Maximum Benefit Election:  An employee must be able to receive the maximum amount of reimbursement (the amount the employee elected to contribute for the year) at any time during the coverage period. Each year an employee may not contribute more than a set contribution limit to a health FSA through salary reductions.  This includes employer contributions that the employee could elect to receive in cash.  It does not include non-elective employer contributions. The contribution limit is subject to cost-of-living indexing for subsequent plan years.

Incurred by a Participant or the Participant’s Spouse or Dependents:  See the Participants and Beneficiaries discussion below on who may benefit from a health FSA.

Not Reimbursed by Other Health Plan Coverage:  A participant must certify that he or she has not received, and will not seek, reimbursement under any other health plan for the same expense.

Uniform Coverage:  The maximum amount of reimbursement from a health FSA must be available at all times during the period of coverage (reduced by the amount of prior reimbursements for the same period of coverage).  For example, an employee that elects $1,000 of coverage effective on January 1 is entitled to reimbursement of up to $1,000 of expenses incurred on January 1, even though no salary deductions have been taken as of that date. Accordingly, the employer is at risk for all or some of that amount if the employee makes an election change or terminates employment prior to the end of the plan year.  Employers often wish to mitigate that risk through a variety of plan features; however, the IRS takes a skeptical view of any designs that eliminate all or substantially all risk of loss to the employer maintaining the plan.  For example, the following plan designs would not be acceptable:

• Limiting reimbursements to the amount of premiums paid.
• Requiring employees to reimburse the plan upon termination of coverage for benefits paid in excess of premiums received.
• Changing the amount of the premium based on the amount of claims paid.

No Deferred Compensation:  A health FSA may not offer any benefit that provides deferred compensation.  This means that plans may not permit an employee to pay for benefits to be received after the plan year in which the payment is made.

Exceptions:  The health FSA rules include two important exceptions to the deferred compensation rule:

• A health FSA is permitted to reimburse employees for orthodontia services before the services are provided but only to the extent that the employee has actually made the payments in advance of the orthodontia services in order to receive the services.
• A health FSA may reimburse employees for medical equipment with a useful life extending beyond the end of the plan year in which the expense is incurred. For example, a health FSA is permitted to reimburse the cost of a wheelchair for an employee.

Grace Period and Carryover

The deferred compensation rule also means that plans may not permit employees to carry over unused elective contributions from one plan year to another.  This is the origin of the use-it-or-lose-it rule.  Any health FSA contributions that are not spent on claims incurred before the end of the plan year are forfeited.  The IRS has relaxed this rule somewhat by permitting health FSAs to adopt either a grace period or limited carryover of unused funds (but not both).

Grace Period:  A cafeteria plan may, at the employer’s option, provide a grace period of up to 2 1/2 months immediately following the end of each plan year.   In that case, an employee who has unused benefits or contributions relating to a health FSA from the immediately preceding plan year, and who incurs expenses for medical care during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year.

Carryover:  A cafeteria plan may, at the employer’s option, provide for a carryover to the immediately following plan year of up to $500 of any amount remaining unused as of the end of the plan year in a health FSA. The carryover may be used to pay or reimburse medical expenses under the health FSA incurred during the entire plan year to which it is carried over.  The amount remaining unused as of the end of the plan year is the amount unused after medical expenses have been reimbursed at the end of the plan’s run-out period for the plan year.  The carryover does not count against or otherwise affect the indexed $2,500 salary reduction limit applicable to each plan year.

ELECTIONS

In order to qualify as a cafeteria plan, a health FSA must observe several rules regarding the election process.  The rules must be written into the plan.

• The plan must provide for elections between taxable and qualified benefits.
• The election must be made prior to the date coverage becomes effective.
• The election must be irrevocable except for the occurrence of certain specified events.

Choosing Between Taxable and Non-Taxable Benefits:  In practice, this generally comes down to the choice between cash or coverage.  If a plan finances benefits through salary reductions, the choice is simply the employee’s receipt of his or her full salary or a lesser amount with the difference used to provide benefits under the health FSA.  Alternatively, the employer could offer additional amounts to the employee who could then chose to take the added amounts in cash or apply them to the FSA.

Prospective Elections:  For existing employees this means that elections for a plan year must be made prior to the start of the plan year.  For new employees, the elections must be made prior to the date they are to become effective.  Proposed IRS rules would permit new employees to make cafeteria plan elections (for coverage under a medical plan) retroactive for up to 30 days back to the date of hire; however, there is some question whether those rules are intended to apply to health FSAs.  Even if they do, employers may not want to incorporate this as it allows for selection against the plan.

Mid-Year Election Changes:  Elections, once made, cannot normally be changed prior to the end of the plan year.  However, a plan may permit an employee to change elections upon the occurrence of specified events.  ComplianceDashboard provides a tool to assist employers in administering election change requests.

 

NON-DISCRIMINATION RULES

Cafeteria plans may not discriminate in favor of highly compensated or key employees (collectively “HC/Ks”) based on eligibility or benefits.  Plans also may not permit HC/Ks to use the cafeteria plan disproportionately to its use by non-HC/Ks.

Health FSAs must pass non-discrimination testing under two separate sets of rules.  The first relates to testing under IRC Section 125 which applies to all cafeteria plans; the second is required by IRC Section 105(h) which applies to employer-sponsored health plans.

IRS proposed rules require testing annually before the end of the plan year.  In practice, plans may wish to test more frequently as correction of any discrimination problems is much easier prior to the end of the plan year.

Simple Cafeteria Plans:  The ACA created a new category of cafeteria plan known as a “simple cafeteria plan.”  A simple cafeteria plan will be deemed to meet the IRS non-discrimination rules for health FSAs (and for certain other components of the plan).  A simple cafeteria plan can only be maintained for a year in which the employer is an “eligible employer” and must observe some contribution, eligibility and participation requirements.

• An eligible employer is one that employed an average of 100 or fewer employees on business days during either of the two preceding years.  If an employer was not in existence during all of the preceding years, the determination may be based on the employer’s reasonable expectations for the average number of employees it will have for the current year.  An eligible employer that establishes a simple cafeteria plan will continue to be an eligible employer for subsequent years until such time as it employs an average of 200 or more employees during a year.
• The eligibility and participation requirements will be met if all employees who had at least 1,000 hours of service for the preceding plan year are eligible to participate and each employee eligible to participate in the plan may, subject to terms and conditions applicable to all participants, elect any benefit available under the plan.
• The contribution requirements are met if the plan requires the employer to make contributions on behalf of each eligible employee who is not an HC/K and without regard for whether the employee makes a salary reduction election.  The amount of the employer contribution must equal either:
  • a uniform percentage (not less than 2 percent) of the employee’s compensation for the plan year, or
  • an amount which is not less than the lesser of
    • 6 percent of the employee’s compensation for the plan year, or
    • twice the amount of the salary reduction contributions of each qualified employee.²

There are currently no regulations addressing simple cafeteria plans.

FUNDING AND TRUST REQUIREMENTS

ERISA

ERISA does not require that a health FSA have a funding source, i.e., a specific account containing funds to be used for benefit payments – otherwise known as plan assets.   However, if a plan does have plan assets, those assets ordinarily must be held in trust.

Employee contributions are always considered plan assets and therefore, absent some exception a health FSA that is funded wholly or in part by salary reductions would need to have a trust.

In fact, the DOL has established just such an exception: a non-enforcement policy (Technical Release 92-01) under which the DOL will permit employee contributions that are withheld pursuant to a cafeteria plan to be kept in the employer’s general assets.  However, employers should be cautious about segregating such funds or otherwise creating an arrangement that gives the appearance that specific funds have been set aside to fund benefits as this may take the plan outside the scope of the non-enforcement policy.

 

FORFEITURES

IRC

Forfeitures, or experience gains as they are also called, arise when a health FSA receives more in contributions than it pays out in benefits.  The IRC provides that forfeiture may be retained by the employer; used to offset experience losses in the year immediately following; returned to employees allocated on a reasonable and uniform basis and without regard for individual claims experience; or used to defray the expenses of plan administration.

ERISA

Health FSAs that are subject to ERISA must also comply with the law’s rules on forfeitures.  ERISA plans do not have the option of returning unspent plan contributions to the sponsoring employer.  Forfeitures are considered plan assets and as such they can never inure to the benefit of the employer but must be used for the exclusive purposes of providing benefits to participants in the plan and their beneficiaries and defraying reasonable expenses of administering the plan.

BONDING

ERISA imposes bonding requirements on persons who handle plan assets.  These will not normally affect employers who collect employee contributions and use a third party administrator to pay claims but they may impact employers who use internal personnel to pay claims.

REPORTING REQUIREMENTS

ERISA³

Health plans, including health FSAs, are subject to Form 5500 reporting requirements absent an applicable exemption (for example, unfunded plans with fewer than 100 participants on the first day of the plan year.)  Note that if Technical Release 92-01 applies, the health FSA will not be deemed “funded” solely because it accepts employee contributions.

CLAIMS PROCEDURES

ERISA/ACA

Health FSAs must comply with the DOL claims and appeals procedures required by ERISA.  However, if they are excepted benefits, they are not required to comply with the enhanced procedures imposed by the ACA.   Most notably, these include the ACA’s external review requirements.

COBRA

A health FSA is a group health plan for purposes of COBRA.  However, COBRA works somewhat differently for FSAs than it does for health plans.

COBRA Notices:  An initial notice must be given at the time of enrollment.  Qualifying event notices must be sent if the plan is obliged to offer COBRA.  While these notices can be combined with the COBRA notices for the employer’s health plan, the content will be different as the conditions under which qualifying event will occur and the available benefits are unique to FSAs.  See below.

Obligation to Offer COBRA: If the FSA is an excepted benefit, the employer does not need to offer COBRA if the maximum amount that the qualified beneficiary can be required to pay for COBRA continuation for the remainder of the plan year equals or exceeds the maximum benefit available under the health FSA for the year.

Conversely, a health FSA must offer COBRA continuation coverage to any qualified beneficiary who experiences a qualifying event during that plan year if, as of the date of the qualifying event, the qualified beneficiary can become entitled to receive during the remainder of the plan year a benefit that exceeds the maximum amount that the qualified beneficiary would have to pay for COBRA continuation coverage for the remainder of the plan year.

Illustration:  An employee elects $1,200 of FSA coverage for which he pays a premium by way of salary reduction of $100 per month.  He terminates employment on June 30 and as of that date he has only used $150 of his available benefit.  Since his remaining benefit for the year ($1,050) is more than the COBRA applicable premium for the remainder of the year ($102 x 6 = $612), the employer must offer COBRA.  On the other hand, if the employee has already used $1,000 of his available benefit, the employer would not need to offer COBRA since the amount of the premium for the rest of the year would exceed the remaining benefit for the year ($200).

Qualified Beneficiary: The health FSA rules regarding who can be a qualified beneficiary are the same as those for health plans in general.  This means that spouses and dependents can be plan participants if they make a COBRA election.

Duration of COBRA Coverage:  COBRA coverage in the context of a health FSA has a different meaning than it has when applied to a medical plan.  Unlike the latter, where COBRA coverage can continue for period of 18 to 36 months, health FSA COBRA coverage needs to extend only to the end of the plan year in which the qualifying event occurred.  However, if the plan has adopted a grace period, the coverage would extend to the end of the grace period.

Benefit Amount:  In the simplest case – that of an unmarried employee with no dependents – the benefit amount is the amount of the employee’s election minus claims paid.  After that, things get complicated.

Employee with Family Members/Termination of Employment: Each qualified beneficiary can make a separate election.  In that case, the remaining benefit for each electing beneficiary is the amount of the employee’s election minus claims paid.

Divorce:  An employee elects $1,200 of FSA coverage for the calendar year.  The employee divorces on July 1 and as of that date, the employee has had $200 in reimbursements from the FSA and the spouse, $100 in reimbursements.  According to an example in the regulations, the spouse should be able to elect COBRA coverage of $1,100; i.e., the maximum reimbursement less only the spouse’s claims.

Child Losing Eligibility: This would be treated the same as the divorce situation.

COBRA Premium:  The COBRA premium for a health FSA is the cost to the plan of providing coverage for similarly situated employees who have not experienced a qualifying event plus 2%.  Accordingly, the monthly premium cost for many plans will be the annual coverage amount divided by the number of months remaining in the year.   However, it may be lower for plans that have large experience gains – i.e., forfeitures – that are not offset by experience losses and expenses.

HIPAA PRIVACY AND SECURITY RULES

A health FSA is considered a health plan for purposes of HIPAA’s privacy and security rules.  Some employers may have the impression that because all their medical plans are insured and the employer receives no PHI (other than enrollment and disenrollment information), they do not need to be concerned about HIPAA’s privacy and security rules.  However, if those employers also sponsor a health FSA, they need to comply with those rules with respect to the FSA.  This is true even if the employer uses a third-party administrator to handle claims and does not otherwise receive PHI.

There is an exception for employers with plans having fewer than 50 participants provided that the employer actually administers the plan.  This is likely to be a rare circumstance.  In this context, the term “participants” means employees who are eligible to participate in the plan even if they do not, in fact, elect coverage.

HEALTH FSAs and HSAs

Health Savings Accounts are trust or custodial accounts created under the Internal Revenue Code.  It permits eligible individuals to establish and make pre-tax contributions to an account which then can be used to pay for certain medical expenses.

Eligible Individuals:  One of the requirements for a person to be an eligible individual is that the individual must be covered under a high deductible health plan (HDHP).   An HDHP is a plan that, among other things, has a statutorily specified minimum deductible and which pays no benefits other than preventive care prior to satisfaction of the deductible.  In addition, an eligible individual cannot have any coverage that is not an HDHP.  However, since a general-purpose health FSA can be used to pay first dollar medical expenses, employees with health FSAs and their tax dependents cannot be eligible individuals.  This includes an employee whose spouse is covered under a general purpose health FSA since the employee’s expenses can be reimbursed under the spouse’s FSA.

Limited-Purpose and Post-Deductible Health FSAs:  Coverage under a limited-purpose health FSA will not prevent a person from being an eligible individual.  A limited-purpose health FSA is one that only reimburses for dental and vision claims.  Likewise, a post-deductible FSA, which only pays claims after the statutory HDHP deductible has been satisfied, will not prevent a person from being an eligible individual.  A plan may also combine a limited-purpose FSA with a post-deductible FSA.