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[Client Alert] IRS Clarifies Cafeteria Plan Flexibility into 2022: Amendments Required to Take Advantage

On February 18, 2021, the IRS provided the necessary clarity by releasing Notice 2021-15, which imposes some additional limitations and provides some expansions to Section 214 of the CAA.


The Taxpayer Certainty and Disaster Tax Relief Act of 2020 (also known as the Consolidated Appropriations Act, 2021 or CAA) was signed into law on December 27, 2020. With regard to flexible spending accounts (FSAs), Section 214 of the CAA provided great flexibility for plan years 2021 and 2022. Please see our January 11, 2021 Client Alert. However, tax consequences of these relaxed rules were unclear.

On February 18, 2021, the IRS provided the necessary clarity by releasing Notice 2021-15.

Notice 2021-15 imposes some additional limitations and provides some expansions to Section 214 of the CAA. Significantly, the Notice expands the mid-year change in election relief to group health plans as long as certain requirements are met. The Notice further addresses the impact on HSAs, COBRA, and nondiscrimination testing with regard to FSA carryovers and grace periods. Moreover, it tightened the plan amendment timeline. Finally, it allows additional time for health FSA and HRA plans to be amended to include OTCs and menstrual care products.

The Notice reiterates the loosened rules as provided in the CAA, with the following clarifications:

Expanded Carryover Rules

  • Carryover to the 2021 Plan Year: This provision allows any unused benefits or contributions in both dependent care and health FSAs from plan years ending in 2020 to be carried over to the plan year ending in 2021;
    • The carryover must follow rules similar to the health FSA rules… however, while health FSA carryovers are normally subject to a $550 cap [as indexed], the Notice specifically states that any unused benefits or contributions may be carried over.
    • Significantly, dependent care FSAs were not previously allowed to have a carryover provision.
  • Carryover to the 2022 Plan Year: This provision allows any unused benefits or contributions in FSAs from plan years ending in 2021 to be carried over to the plan year ending in 2022;
    • We find this provision important especially in situations involving the dependent care FSAs. These FSAs have a maximum reimbursement of $5,000 per calendar year in order to be excluded from gross income.  See Code section 129(a). If an employee is allowed to carry over unused contributions into 2021 from 2020, but had also elected a full $5,000 for plan year 2021, s/he would have an overfunded account. This can be handled in one of two ways: (1) carrying over the extra funds from 2021 to 2022, and/or (2) prospective election changes for FSAs for plan years ending in 2021 without regard to the strict status change rules (see the Change in Election section below). With regard to the latter, employees can reduce their dependent care election for 2021 and prevent future contributions from being made.
      • Note: While Example 3 of the Notice indicates that more than $5,000 can be reimbursed, we recommend exercising caution here. Code section 129(a), which clearly limits the dependent care exclusion from gross income to $5,000 of services rendered during a taxable year, was not amended. Code 129(a)(2)(A) says: “The amount which may be excluded under paragraph (1) for dependent care assistance with respect to dependent care services provided during a taxable year shall not exceed $5,000.”
    • While widely understood, the Notice clarifies that carryover of amounts in a general-purpose FSA will make an employee ineligible for HSAs. Employers may amend their plans to convert general-purpose FSAs to ones compatible with HSAs (limited-purpose or post-deductible) or may amend their cafeteria plans to allow employees to opt out of the carryover feature to preserve their eligibility for HSAs.
    • This limited relief allows the Expanded Carryover to be adopted, regardless of whether the plan currently has a grace period or carryover or not (having carryovers and grace periods in the same years normally would not be allowed – see Notice 2013-71).
    • Moreover, the Notice provides that an employer may limit the carryover amount and may limit the carryover to a specified date during the plan year.
    • Plan amendments are required.
  • However, an employer may not adopt both the Extended Grace Period and Expanded Carryover rules with respect to a particular FSA.

Extended Grace Periods

  • Grace Periods: Health or dependent care FSAs may adopt an extended grace period for plan years ending in 2020 or 2021, which is extended from the traditional two months and 15 days to a full 12 months after the end of such plan year in order for unused benefits or contributions to be utilized.
    • As with the Expanded Carryovers, Extended Grace Periods in a general-purpose FSA will make an employee ineligible for HSAs. Employers may amend their plans to convert general-purpose FSAs to ones compatible with HSAs (limited-purpose or post-deductible) or may amend their plans to allow employees to opt out of the grace period feature to preserve their eligibility for HSAs.
    • This limited relief allows the Extended Grace Period to be adopted, regardless of whether the plan currently has a grace period or carryover or not (having carryovers and grace periods in the same years normally would not be allowed – see Notice 2013-71).
    • An employer may limit the grace period to a specified date during the plan year.
    • Plan amendments are required.
  • Post-Termination Health FSA Reimbursements: Health FSAs are now allowed to continue to reimburse former participants for claims incurred post-termination similar to dependent care FSAs, namely:
    • Employees who ceased participation in the plan during calendar years 2020 or 2021 may continue to receive reimbursements from unused benefits or contributions through the end of the plan year in which participation ceased (including any grace period).
    • Cessation of participation includes termination of employment, change in employment, or a new election during calendar year 2020 or 2021.
    • This is only allowed if Extended Grace Period is adopted. It is not applicable for Expanded Carryovers…
    • COBRA still applies.
    • An employer may limit this to a specified date during the plan year.
    • Employers may limit the amount in a health FSA to the amount of contributions made by the employee from the beginning of the plan year in which the employee ceased to be a participant (i.e., not including carryover/grace period amounts).
    • Participation in a general-purpose FSA will make an employee ineligible for HSAs. Employers may amend their plans to convert general-purpose FSAs to ones compatible with HSAs (limited-purpose or post-deductible) or may amend their plans to allow employees to opt out of the extended participation feature to preserve their eligibility for HSAs.
    • Plan amendments are required.
  • However, an employer may not adopt both the Extended Grace Period and Expanded Carryover rules with respect to a particular FSA.

Dependent Care FSA Age Out Rule

  • Dependent Care FSA Age Out Rule: In order for eligible employees to receive reimbursement for dependent care assistance, their dependent must be under the age of 13 when the expenses were incurred. However, for employees who were enrolled in the dependent care FSA (as long as the regular enrollment period was on or before January 31, 2020), age 14 is substituted for age 13 for the last plan year, and, if the employee had an unused balance in the FSA for such plan year, age 14 may also be substituted for the subsequent plan year with respect to those unused amounts.
  • Plan amendments are required.

Nondiscrimination

  • Amounts available due to either the Expanded Carryover or Extended Grace Period, as well as the Dependent Care FSA Age Out Rule, are not taken into account for Section 125 and/or Section 129 nondiscrimination testing. However, otherwise, the nondiscrimination rules remain in effect.

Normal Rules Resume for Plan Years Ending In/After 2022

  • Normal FSA rules resume for plan years ending in or after 2022,
    • Calendar year plans with regular grace periods will allow all amounts remaining at the end of the 2022 plan year to be used during the first 2.5 months of 2023.
    • Calendar year plans with regular carryovers will allow up to $550 (as inflated) to be carried over and used in any month of 2023.
    • Carryovers, as previously, will only be allowed for health FSAs.

Change in Election

  • Change in Election for FSAs: Similar to IRS Notice 2020-29, but for plan years ending in 2021, health and dependent care FSAs may allow employees to make mid-year election changes prospectively without regard to the rigid change in status rules Under Treas. Reg. 1.125-4.
  • Change in Election for Group Health Plans (health / dental / vision):
    • Although the CAA did not so provide, Notice 2021-15 also allows mid-year changes under a cafeteria plan for group health plans without regard to change in status rules as long as certain requirements are met.
    • Similar to relief provided by Notice 2020-29, an employer may amend one or more of its Section 125 cafeteria plans to allow employees to:
      • (1) make a new election for employer-sponsored health coverage on a prospective basis, if the employee initially declined to elect employer-sponsored health coverage;
      • (2) revoke an existing election for employer-sponsored health coverage and make a new election to enroll in different health coverage sponsored by the same employer on a prospective basis (including changing enrollment from self-only coverage to family coverage);
      • (3) revoke an existing election for employer-sponsored health coverage on a prospective basis, provided that the employee attests in writing that the employee is enrolled, or immediately will enroll, in other health coverage not sponsored by the employer.
    • The Notice includes sample written attestation language.
  • Plan amendments are required.
  • The Notice clarifies that health FSAs may only be used for medical care expenses and dependent care FSAs may only be used for dependent care expenses.
  • Employers can limit election changes in a plan year to increases in coverage, decreases in coverage, number of changes, and others.
  • Under this relief, employers may allow employees to change from general-purpose health FSAs to HSA-compatible FSAs for a portion of the year.
  • No cash outs of FSAs are allowed.

COBRA

  • The Notice clarifies the application of COBRA with regard to these unique changes:
    • Extended Grace Period: Health FSA spend down amounts for terminated employees will not prevent individuals with qualifying events from having a loss of coverage (i.e., they will still have the right to COBRA), and the employer must provide the COBRA notice.
    • Expanded Carryover or Extended Grace Period: If a terminated employee qualifies for COBRA, s/he may elect and access the additional funds made available due to the carryover or grace period. However, these excess amounts will not be included when determining the applicable COBRA premium.

Amendments

  • To allow any of the above provisions, the cafeteria plan or arrangement must be amended to allow for such provisions.
  • Rarely are cafeteria plan amendments allowed to take retroactive effect, however, this Notice provides some of those rare opportunities. A cafeteria plan amendment to adopt one of the above provisions may be implemented retroactively if:
    • (1) the amendment is adopted not later than the last day of the first calendar year beginning after the end of the plan year in which the amendment is effective, and
    • (2) the plan or arrangement is operated consistent with the terms of the amendment during the period beginning on the effective date of the amendment and ending on the date the amendment is adopted.
  • For a calendar year plan, if 2020 FSA amounts carry over to 2021, the amendment must be adopted by December 31, 2021. For a non-calendar year plan where the last day of the applicable plan year ends in 2021, the plan amendment must be adopted by December 31, 2022.
  • With regard to amendments to allow over-the-counter drugs and menstrual care products to be reimbursed from health FSAs, the Notice also clarifies that retroactive amendments are allowed:
    • Under the CARES Act, FSAs/HRAs (and HSAs) may reimburse over-the-counter drugs and menstrual care products incurred after December 31, 2019 if the FSA/HRA is amended. Typically, as mentioned above, Code section 125 only allows reimbursement after the plan is amended (and Code section 105(b) only allows exclusion from gross income if the plan covers the expense on the date the expense was incurred). However, this Notice clarifies amendments and coverage can be retroactive to January 1, 2020.

Form W-2 Reporting

  • Amounts contributed to dependent care FSAs are required to be reported in Box 10 (the employee’s salary reduction amount elected plus any employer matching contributions).  However, this does not need to include account amounts that remain available during the grace period. The Notice clarifies that this rule continues to apply for with regard to amounts available due to Expanded Carryovers and Extended Grace Periods.

Conclusion

Obviously there are numerous relaxed rules contained within this Notice, each with its own set of requirements and implications. As always, consultation is important to determine if these changes will be of benefit to employers and their employees. Many factors should be considered, such as nondiscrimination rules, adverse selection with allowing mid-year changes, whether extending health FSA reimbursement provisions will negatively affect health savings accounts, and additional required employee communications.

Plan sponsors must determine whether they wish to proceed with any of the above provisions, largely in part depending on whether typical FSA rules would result in unprecedented forfeitures due to the pandemic. If so, they must communicate such provisions with their workforce and must administer the cafeteria plan or arrangement accordingly as of the amendment’s effective date, even if the amendment is adopted at a later date.

As you are well aware, the law and guidance are rapidly evolving in this area. Please check with your Fraser Trebilcock attorney for the most recent updates.


We have created a response team to the rapidly changing COVID-19 situation and the law and guidance that follows, so we will continue to post any new developments. You can view our COVID-19 Response Page and additional resources by following the link here. In the meantime, if you have any questions, please contact your Fraser Trebilcock attorney.


Elizabeth H. Latchana specializes in employee health and welfare benefits. Recognized for her outstanding legal work, in both 2019 and 2015, Beth was selected as “Lawyer of the Year” in Lansing for Employee Benefits (ERISA) Law by Best Lawyers, and in 2017 as one of the Top 30 “Women in the Law” by Michigan Lawyers Weekly. Contact her for more information on this reminder or other matters at 517.377.0826 or elatchana@fraserlawfirm.com.


Brian T. Gallagher is an attorney at Fraser Trebilcock specializing in ERISA, Employee Benefits, and Deferred and Executive Compensation. He can be reached at (517) 377-0886 or bgallagher@fraserlawfirm.com.