IRS Addresses Health FSA Carryovers and HSA Eligibility

Practical Law Legal Update 4-563-1968 (Approx. 5 pages)

IRS Addresses Health FSA Carryovers and HSA Eligibility

by Practical Law Employee Benefits & Executive Compensation

Health FSA Carryovers and HSA Eligibility

The first memorandum addresses the interplay between health FSA carryovers and eligibility for participation in an HSA (see Practice Notes, Cafeteria Plans and Defined Contribution Health Plans). The memorandum expands on IRS guidance, issued last fall, under which cafeteria plans can be amended to allow up to $500 of unused health FSA amounts remaining at the end of a plan year to be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year (see Legal Update, In Change to "Use-or-Lose" Rule, IRS Permits $500 Carryover of Health FSA Balances).

The memorandum addresses several issues involving how health FSA carryovers impact HSA eligibility, explaining that:

An individual covered by a general purpose health FSA (that is, one that reimburses medical care expenses under Section 213 of the Internal Revenue Code (IRC)) solely because of the carryover of unused health FSA amounts from the prior year may not contribute to an HSA. This is the rule even for months in the plan year after the health FSA no longer has amounts available to pay or reimburse medical expenses.
An individual who participates in a general purpose health FSA and elects to participate in an HSA-compatible health FSA (see HSA-compatible Health FSAs) for the following year may:
- choose to have any unused amounts from the general purpose health FSA carried over to the HSA-compatible health FSA; and
- not carry over unused amounts to a non-health FSA or another type of cafeteria plan benefit.
Thus, it is not required that unused amounts be carried over from one general purpose health FSA to another.
An individual who participates in a general purpose health FSA and elects, for the following year, to participate in an HSA-compatible health FSA and have unused amounts from the general purpose health FSA carried over to the HSA-compatible health FSA is eligible to contribute to an HSA (if otherwise eligible under the HSA rules).
A cafeteria plan that offers a general purpose health FSA and an HSA-compatible health FSA may:
- automatically treat an individual who elects coverage in a high-deductible health plan (HDHP) for the following year as enrolled in the HSA-compatible health FSA; and
- carry over any unused amounts from the general purpose health FSA to the HSA-compatible health FSA for the following year.

Also, a cafeteria plan may provide that if an individual participates in a general purpose health FSA that includes a carryover feature, the individual may elect, before the beginning of the following year, to decline or waive the carryover for the following year. An individual who declines under the cafeteria plan terms may contribute to an HSA in the following year (if otherwise eligible under the HSA rules).

The memorandum also addresses how the uniform coverage rule applies when an individual elects to carry over unused amounts from a general purpose health FSA to a HSA-compatible health FSA. Under the uniform coverage rule, the maximum amount of reimbursement from a health FSA must be available at all times during the coverage period (though reduced as of any given time for prior reimbursements for the same coverage period). In particular, the memorandum focuses on how the uniform coverage rules may apply during the general purpose health FSA's run-out period (that is, the time after the end of a coverage period during which participants may ask for reimbursement of expenses relating to the period). During the run-out period:

Unused health FSA amounts may be used to reimburse any medical expenses allowed under IRC § 213(d) incurred before the end of the general purpose health FSA's plan year.
Claims covered by the HSA-compatible health FSA must be timely reimbursed up to the amount elected for the HSA-compatible health FSA plan year.
Claims that exceed the elected amount may be reimbursed after the run-out period when the amount of any carryover is determined.

HSA-compatible Health FSAs

Under IRS guidance addressing HSA eligibility during a cafeteria plan grace period (IRS Notice 2005-86) (see Practice Note, Cafeteria Plans: Grace Period Exception to Use-or-Lose Rule), an HSA-compatible health FSA is one of the following:

A limited purpose health FSA, which pays or reimburses expenses only for preventive care and "permitted coverage" (for example, dental and vision care).
A post-deductible health FSA, which pays or reimburses preventive care and other Section 213(d) medical care expenses, only if incurred after the minimum annual deductible for an HDHP under IRC § 223(c)(2)(A) is met.
A combined limited-purpose and post-deductible health FSA.

Correction Procedures for Improper Health FSA Payments

The second memorandum indicates that correction procedures for debit card payments under the proposed cafeteria plan regulations (Prop. Treas. Reg. § 1.125-6(d)(7)) may be applied to improper payments under a health FSA. These procedures include:

Debit card deactivation pending recovery of improper payments.
An employer demand for repayment from the employee and withholding of the improper charge from the employee's pay.
Use of an offset procedure for outstanding amounts, such as a reduction from subsequent, substantiated expense claims.
Treatment by the employer of overpayments that remain unpaid, after the other procedures are followed, as general business indebtedness.

A third party administrator (TPA) may apply the overpayment correction procedures on an employer's behalf, though the employer is ultimately responsible for compliance.

An employer may choose the order in which it applies certain of the correction procedures, but:

Must apply this order consistently for all participants in its health FSA.
May apply the correction procedure of treating the improper payment as any other business indebtedness only after it has pursued the correction methods of demanding repayment from the employee, withholding the charge from the employee's pay and using an offset.

According to the IRS:

Forgiveness of improper payments as uncollectible business debt should be used as an exception, not the general practice.
The correction procedures of demanding employee repayment, withholding a charge from the employee's pay and using an offset should be applied during the plan year in which the improper payment was made to a participant.

If all other correction procedures have been exhausted and the employer treats the improper payment as business indebtedness, the amount generally should be reported by the employer as wages on the employee's Form W-2. This amount is:

Subject to withholding for income tax and FICA and FUTA.
Reportable in the employee's tax year in which the indebtedness is forgiven.

Practical Impact

Although the IRS is not bound by these legal memoranda (and they may not be used or cited as precedent), the memoranda offer a window into the agency's views on health FSA carryover issues that are not yet addressed in formal guidance. As a result, the memoranda may be useful for employers interested in design options that would permit them to use a health FSA carryover without negatively impacting HSA eligibility.

IRS Addresses Health FSA Carryovers and HSA Eligibility | Practical Law