IRS Permits Employers To Temper 'Use It or Lose It' Rule

Executive Summary

In Notice 2005-42, the IRS modified its stance on the "use it or lose it" rule. Previously, the IRS required forfeiture of unused balances in health and dependent care spending accounts at year-end. The IRS now permits employers to allow a grace period of two and one half months immediately following the end of each plan year, during which time unused benefits or contributions may be used by plan participants.  Because this new grace period is optional, a plan amendment must be adopted if a plan sponsor wishes to grant participants the additional time to use account balances. Such an amendment will be popular with employees, but will require some additional administration.

Background

Spending accounts for un-reimbursed health care expenses and dependent day care expenses are a popular feature in many cafeteria plans. Those employers that sponsor these arrangements, and the employees that use the arrangements, are almost certainly aware of the one rule that seems to be the most troublesome for participants. That rule is the "use it or lose it rule," which causes the automatic forfeiture at year-end of unspent funds in these accounts.
  
The IRS has always viewed the "use it or lose it" rule as statutory in nature, with the rule being derived from the prohibition on deferral of compensation in a cafeteria plan. In order to avoid the deferral of compensation, a cafeteria plan must require that unused contributions or benefits remaining at the end of the plan year be "forfeited." Thus, while the IRS does not feel as though it can eliminate the rule, it has stretched the requirements in Notice 2005-42.

The IRS examined other areas of tax law that provide for a short, limited grace period for what would otherwise be considered deferred compensation. In these examples, compensation for services paid in the year following the year in which the services that are being compensated were performed is not treated as "deferred compensation." Consistent with these other areas of tax law, the Treasury and IRS decided to modify the current prohibition on deferred compensation in the proposed regulations under § 125 to permit a two and one half month grace period after the end of the plan year. During the grace period, unused benefits or contributions may be spent. 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.   

Amendment to the Plan is Required

 A cafeteria plan document must be amended to provide for a grace period immediately following the end of each plan year. This amendment is not mandatory. Should an employer choose to implement the new rule, the following conditions and limitations will apply.

• The grace period must apply to all participants in the cafeteria plan. 
• The grace period must not extend beyond the fifteenth day of the third calendar month after the end of the plan year to which it relates (i.e. March 15 for calendar year plans).
• The end of the grace period is the last day expenses can be incurred; a run out period following the end of the grace period is still permitted.
• During the grace period, a 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 particular qualified benefit. For example, unused amounts in a health flexible spending arrangement may not be used to pay or reimburse dependent care expenses.
  • An employer wishing to adopt the additional time period for the current cafeteria plan year (and subsequent cafeteria plan years) must amend the cafeteria plan document before the end of the current plan year. This is consistent with the IRS position that cafeteria plans may not be adopted retroactively.
  • The amendment will have to be communicated to employees. Plan sponsors that decide to adopt the amendment should do so sooner rather than later, to allow adequate time for communicating plan changes. In addition, employees will generally appreciate the extra time to properly allocate their expenses. 

Overall Considerations

Employees are certain to like the new rule, as it will lessen the likelihood that they will lose money. Even if all the new rule does is delay the mad rush to spend remaining account balances, just the delay from late December to mid-March will be a most welcome change. The rule also has the potential to increase participation in flexible spending plans, which generally save both the employee and the employer money in payroll taxes.

The downside to implementing the new rule will be the additional administration in tracking claims during the early months of the year, and making sure that the proper time period has been recorded.