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FSA on an accrual basis


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Hey, everyone - First time caller!

I have a client with a Standard Health FSA. It operates on a calendar year basis. However, the employer's payroll processes two weeks in arrears. 

Tax question as to whether the employer can deduct the final payroll from 2020 when the final payroll for 2020 is actually not paid out until the first payroll period in 2021. In other words, the work performed between December 15 and December 31 is paid on the January 15 payroll. That first payroll for 2021 is included as income for the 2021 W-2s - not 2020.

Has anyone dealt with this? The plan language is vague as to "compensation". Trying to determine whether there are different deductibility rules for cash basis versus accrual basis accounting.


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Yeah I agree.  There are no explicit rules (that I'm aware of) for this issue on the Section 125 side for pre-tax contributions to FSA and/or health and welfare benefits. However, the IRS does have guidance for how to this issue on the 401(k) side. I’ve always felt comfortable piggybacking on the 401(k) rules for this purpose.

Generally, compensation must actually be paid or made available to an employee within the year to be counted as compensation for that year. However, year-end payrolls do not always pay out by the end of the year. 

The qualified plan regs allow for adjustments to address this minor timing difference. The plan may provide that compensation for a year includes amounts earned during year one but not paid until year two solely because the timing of pay periods/pay dates. 

There are three conditions to taking this approach if they wanted to use it:

  1. The paycheck must be during the first few weeks of year two;
  2. The amounts must be included in year one plan comp on a consistent basis for all similarly situated employees (no one-offs for timing which year the contributions count toward); and
  3. No compensation is included in more than one year (the contributions must only count toward year one).

I’ve copied the reg below for reference.

Treas. Reg. §1.415(c)-2(e)(2):

(e) Timing rules.
(1) In general.
(i) Payment during the limitation year. Except as otherwise provided in this paragraph (e), in order to be taken into account for a limitation year, compensation within the meaning of section 415(c)(3) must be actually paid or made available to an employee (or, if earlier, includible in the gross income of the employee) within the limitation year. For this purpose, compensation is treated as paid on a date if it is actually paid on that date or it would have been paid on that date but for an election under section 125, 132(f)(4), 401(k), 403(b), 408(k), 408(p)(2)(A)(i), or 457(b).
(2) Certain minor timing differences. Notwithstanding the provisions of paragraph (e)(1)(i) of this section, a plan may provide that compensation for a limitation year includes amounts earned during that limitation year but not paid during that limitation year solely because of the timing of pay periods and pay dates if—
(i) These amounts are paid during the first few weeks of the next limitation year;
(ii) The amounts are included on a uniform and consistent basis with respect to all similarly situated employees; and
(iii) No compensation is included in more than one limitation year.

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