The IRS recently issued Notice 2012-40 providing guidance on the implementation of the $2,500 limit on salary reduction contributions to health flexible spending arrangements (FSAs) added under the Patient Protection and Affordable Care Act.  The notice also offers some interesting, and possibly encouraging, insight into where the IRS may be heading as it works to finalize the currently proposed Code Section 125 plan regulations.

Here are the key points plan sponsors and other responsible fiduciaries need to know about this new guidance: 

• The $2,500 health FSA limit applies beginning January 1, 2013 for calendar year plans, and the first day of the plan year that begins after December 31, 2012 for non-calendar year plans.
• The limit applies only to salary reduction contributions under health FSAs, and does not apply to employer contributions.  However, if the employer provides a contribution (such as a flex credit, wellness incentive or other non-elective employer contribution) that the employees can elect to receive as cash or as a taxable benefit, then the contribution is treated as a salary reduction contribution subject to the limit.
• For health FSAs that provide a grace period for using unused salary reduction contributions from the prior plan year, the unused contributions for plan years beginning in 2012 or later that are carried over into the grace period will not count against the limit for the subsequent plan year.
• The $2,500 limit will be indexed for cost-of-living adjustments for plan years beginning after December 31, 2013.  If a health FSA has a short plan year after 2012, the applicable limit must be prorated based on the number of months in the short plan year.
• Plan sponsors can amend their health FSA to include the $2,500 limit as late as December 31, 2014, as long as the amendment is retroactively effective for plan years beginning after December 31, 2012, and the FSA is operated to reflect the limit beginning on the effective date.  If the FSA is timely amended, the notice provides relief from disqualification under Code Section 125 when the limit is exceeded by one or more participants if certain conditions are met.

The 125 plan regulations proposed in August 2007 require plan amendments to be adopted before they become effective.  The retroactive amendment relief provided in Notice 2012-40 may indicate the IRS is considering relaxing the “prospective-only” amendment rule in the proposed regulations. 

Finally, the IRS requested comments on whether the health FSA “use it or lose it” rule should be modified.  Under that rule, unused amounts in a participant accounts at the end of the plan year (or applicable grace period) are forfeited.  This request for comment suggests the IRS may be willing to provide additional flexibility in the operation of the “use it or lose it” rule because the $2,500 limit itself limits the extent to which these amounts may accumulate over time.