By: HUB’s EB Compliance Team
Two recent IRS information letters confirm that existing rules governing flexible spending accounts and qualified transportation fringe benefits continue to apply, even during a pandemic. While information letters are not binding guidance that employers can rely on, they helpfully restate and reinforce key tax law principles.
No Refunds from FSAs
In the first information letter, the IRS confirmed to New Hampshire Senator Hassan that dependent care flexible spending accounts (“FSAs”) cannot refund (or “cash out”) unused funds back to the employee. In other words, even if an employee legitimately complained that the COVID-19 crisis blocked his or her ability to spend 2020 FSA funds as originally planned, amounts in the FSA cannot be returned to the individual and, if unused, will be subject to forfeiture under the “use it or lose it” rule.
In the response, the IRS mentions the significantly expanded election flexibility that it allowed employers to offer in Notice 2020-29 (discussed here). It then goes on to say that, even with this improved flexibility, there’s still no opportunity to directly refund unused FSA dollars (Note: While this letter specifically addresses dependent care FSAs, the same restriction applies to health FSAs).
Strategies in the Absence of Refunds
Although employers cannot refund unused FSA amounts, employers do enjoy several compliant options to enable participants to use their FSA dollars that would otherwise be forfeited:
- Adopt a Grace Period: This option allows employees to use funds contributed in 2020 for expenses incurred in the first two and a half months of 2021. This plan design option can be used for both dependent care or health care FSAs.
- Adopt a Carryover (health FSAs only): Although not available for dependent care FSAs, health FSAs can allow up to $550 of unused funds from 2020 to be used for the entire 2021 calendar year. Importantly, the health FSA can only adopt a grace period OR carryover (or neither), but not both. More details and consideration on these two options (and their impacts on the ability of employees to make health savings account (“HSA”) contributions) are available here.
- Expand available expenses (health FSAs only): As we discussed here, the CARES Act allows health FSAs to pay for over-the-counter medical items and menstrual products purchased in 2020 and beyond. Employees with leftover health FSA funds may be able to spend down their accounts on these items.
Adding any of the above-plan design options (to the extent they don’t already exist) will likely require a corresponding employer education campaign to alert employees and explain how FSA users can salvage dollars that might otherwise be forfeited. Employees need this educational insight to make optimally informed 2021 FSA elections based on any new plan design changes.
If open enrollment is already closed, the employer could reopen the FSA election period before year end to accommodate any late decision to use a grace period or carryover. Additionally, any amendments implementing these changes need to be adopted before the end of the year.
Qualified transportation fringe benefits are comparatively easier. In this second IRS information letter, the IRS confirms that transit benefits withheld from an employee’s pay cannot be refunded.
However, as noted in the letter, under applicable tax rules, an employee can stop contributing for any month and roll unused funds over to the following year. In other words, an employee could stop contributing for any month (if they haven’t already done so) and use previously contributed funds in a later month or year. Suspending new contributions until existing funds can be compliantly spent for transportation benefits is an easy and effective way of re-setting the balance for COVID-19 impacted transportation accounts.
Employers are undoubtably fielding many new questions about how unused funds will be treated in these various accounts. Although the IRS offers some useful options for these various spending accounts, employers that want to provide maximum employee flexibility for FSAs should realize that the clock is ticking. If an employer wishes to incorporate any of the optional plan design features for FSAs it must act quickly to adopt plan changes and communicate the news to employees so they can respond appropriately.
NOTICE OF DISCLAIMER
The information herein is intended to be educational only and is based on information that is generally available. HUB International makes no representation or warranty as to its accuracy and is not obligated to update the information should it change in the future. The information is not intended to be legal or tax advice. Consult your attorney and/or professional advisor as to your organization’s specific circumstances and legal, tax or other requirements.