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Click here to return to this month's Article Index The Cutting Edge™ July 2005Public PolicyCafeteria Tax PlansBy John Satagaj, WMMA Legislative Counsel, email@jsatlaw.com The IRS did something recently that I thought was pretty "cool." If you offer your employees benefits under a "cafeteria plan" that allows them to secure benefits with pre-tax dollars, you and they are familiar with the phrase "use it or lose it.' Under a qualified program, if you do not use the designated benefits by the end of the year, you lose the income. A cafeteria plan is defined as a written plan maintained by an employer under which all participants are employees, and the participants may choose among two or more benefits consisting of cash and qualified benefits. A "qualified benefit" includes employer-provided accident and health plans, group term-life insurance, dependent care assistance programs, and adoption assistance programs The IRS has decided it has the authority to allow for a grace period of two and one-half months at the end of the plan year before the "use-it-or-lose-it" penalty kicks in. The grace period must apply to all participants in the cafeteria plan. Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the immediately preceding plan year. The grace period must not extend beyond the fifteenth day of the third calendar month after the end of the immediately preceding plan year to which it relates (i.e., "the 2 and 1/2 month rule"). 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. 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 elected to pay or reimburse medical expenses in a health flexible spending arrangement (FSA) may not be used to pay or reimburse dependent care or other expenses incurred during the grace period. For example, an employer with a cafeteria plan year ending on December 31, 2005, amended the plan document before the end of the plan year to permit a grace period which allows all participants to apply unused benefits or contributions remaining at the end of the plan year to qualified benefits incurred during the grace period immediately following that plan year. The grace period adopted by the employer ends on the fifteenth day of the third calendar month after the end of the plan year (March 15, 2006 for the plan year ending December 31, 2005). Employee X timely elected salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2005. As of December 31, 2005, X has $200 remaining unused in his health FSA. Employee X timely elected salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2006. During the grace period from January 1 through March 15, 2006, X incurs $300 of unreimbursed medical expenses. The unused $200 from the plan year ending December 31, 2005 is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2006, X has no unused benefits or contributions remaining for the plan year ending December 31, 2005. The remaining $100 of medical expenses incurred between January 1 and March 15, 2006 is paid or reimbursed from X's health FSA for the plan year ending December 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2006. I believe we can go one step further and through the Small Business Legislative Council (SBLC), of which WMMA is a member and on whose board Ken Hutton serves, we are working to make cafeteria plans more attractive to small businesses. On April 6, 2005, Senator Olympia Snowe introduced the "SIMPLE Cafeteria Plan Act of 2005," S. 723. It would amend the tax code so that owners of small businesses, including partners and S-corporation stockholders who own more than two percent of the stock, to participate in a cafeteria plan if they worked in the business. Under current tax law, small business owners are excluded because they are not "employees," even if working full-time, but rather are self-employed individuals and thus ineligible by definition. The measure also would permit the carryover of unused flexible spending accounts funds, as well as simplifying and increasing dependent care accounts for employers of all sizes. It would allow cafeteria plans to offer long-term care insurance as an optional benefit for the employees to select. It eliminates the despised "use-it-or-lose-it" rule all together. SBLC feels that chances for passage this year are good. The issue has been steered towards the health care debate and out of the tax arena. It is hoped that this measure can become part of any health care legislation that moves this year, perhaps association health plans. Table of Contents
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