Can 125 Plan require payment of balance of reimbursement account at employee termination?

[Guest Rider]

We are being presented with a change to our plan. Under the medical reimbursement section there is now a requirement that if an employee terminates, they must pay the balance of their election. For example, if an employee signs up for $50/mo. and leaves the company mid year after contributing $300, the company will take the remaining $300 out of the last paycheck. Can they do this?

[papogi]

No. This practice eliminates any risk to the employer. There must be risk-shifting between the employee and employer for the FSA to be called "insurance" by the IRS and enjoy the tax advantages of the benefit.

[MGB]

Be very careful -- there are TPAs, consultants, lawyers, etc. running around pushing this kind of structure. They could be setting you and your employees up to some nasty tax consequences when the whole plan is shut down by the IRS.

I completely agree with papogi that this is not allowed.

[KJohnson]

At least as to uniform coverage, I think I disagree based on the question posed. You clearly CANNOT take amounts out of the paychecks of only those individuals with "negative balances". However, under the applicable uniform coverage regulations it would appear that you may be able to take the remainder of the annual election out of all terminated employees last paychecks including those with "positive" account balances. In essence you are requiring all employees to continue coverage until the end of the year. The EBIA manual (see p. 646) seems to acknowledge that this works under uniform coverage but raises some interesting COBRA questions. You also might want to look at this link:

http://benefitslink.com/modperl/qa.cgi?db=qa_125&id=7

[MGB]

Just because it passes the uniform coverage requirement still leaves the main issue as a problem: There MUST be a risk of loss to the plan sponsor in order to have a plan. If the contributions for the rest of the year is taken out of the employee's paycheck, there is no risk to the plan sponsor and the plan will be rejected by the IRS.

[KJohnson]

Uniform coverage and the "risk of loss" are contained in the same Q&A in the regs. I guess there is a question of how much risk do you need to have. If you only apply it in terminations not due to death, do you have some risk with employees who die? If the employee does not have enough in his or her paycheck, do you have some risk? Harry Beker (the IRS' "frontman" on 125 issues) stated the following at one conference several years back:

Robert Richter

The next one relates to how to handle people who terminate employment. They're in a health care reimbursement plan and they've been reimbursed more than their contribution to date. And many employers would like to go out to the employees and take the remaining amount, their annual election, out of the last paycheck. Do you think that can be done? What are the prospects of the employer collecting from the employee for the full year?

Harry Beker

I've addressed this situation in the past. In fact, there is a way to get at the last paycheck. First of all, the cafeteria plan has to provide that if an employee terminates he's simply not permitted to leave the plan. In fact, participants in the plan remain participants for the entire cafeteria plan year. If your cafeteria plan has that type of provision, then I think it's legitimate if the employer can withhold not only last paycheck, but any additional compensation due the employee with the caveat that we're speaking about all employees in the plan, whether or not the employee has a deficit in their account or positive balance.

So you take a situation where someone has elected a flexible health, flexible spending account, has made contributions, has never submitted a claim and in fact and terminates and in fact has a huge amount sitting in his account. If the employer wants to go after the employee who has a deficit in his account, he's going to have to go after an employee that has a positive balance in the account.

And what we're talking about is the amount up to the amount the individual has elected. The fact that there's a deficit is just totally irrelevant. What we're concerned about is that the employee has elected X dollars that he's agreed to put into the flexible spending account and so that's what the employer should be concerned about. And to the extent some of that can be obtained through the last paycheck or some other compensation due the employee. That's okay.

Except let me add another caveat. There are a lot of states or some states that don't permit employers to attach an individual's last paycheck under any circumstances. So in those states, this option is not available. In addition, let me add another caveat. In that if an employee that terminates from a health flexible spending account has COBRA rights so that if the employee elects COBRA, contributions have to be made on the same basis that they were made while he was an employee. So again, the employer couldn't attempt to get a lump sum payment from the last paycheck or any other source.

Of course these are all informal non-binding comments and I think MGB raises a concern. That said, the "noise" from the IRS is that such a plan design is permissible.

[GBurns]

KJohnson,

After reading the content of your post, I would say that a plan design as described in the original post, which only goes after terminated employees with deficit balances, would NOT be permissible according to what Mr. Beker said.

What "noise" from the IRS" are you referring to?

[KJohnson]

GBurns--I would suggest reading the original post again. There was no indication that they would be taking the money out of the last paychecks of only people with negative account balances The practice described in the original post is in line with what Harry Beker has said is acceptable.

I think MGB makes a valid point. Beker may have just been focusing on uniform coverage under Q&A 7(b)(2) as oppsoed to the amount of risk there must be under 7(a) of the same Q&A. However, as evidenced by the link to the Q&A column on benefitslink that I referenced, a number of practioners have adopted that plan design based on Beker's comments. I am not sure that I would recommend this plan design for policy reasons, but I frankly think that, based on Beker's repeated representations, there is little fear of the IRS "disqualifying" a 125 plan because of it.

[oriecat]

There could still be a modicum of risk to the employer, if the terminating employee did not have enough funds in their final paycheck to pay for the remainder of the annual election.

[GBurns]

KJohnson,

Maybe I should have stated "employees with negative election balances" which is what was indicated in the original post rather than just using the term "deficit balances".

[KJohnson]

Just taking it out for everyone with a "negative election" balance is fine under Beker's reasoning --since anyone who terminates prior to the last payroll deduction period in the plan year will have a "negative eleciton" balance. However, just taking it out for people who have a negative account balance is, of course, prohibited.

[Guest Rider]

This particular language does not make a distinction as to whether or not there is a positive or negative balance at termination. Also, there is a directive that says that if there is not enough money in your last paycheck to cover the remaining amount due under the election, the employer will make up the difference.

[MGB]

So that means if a person works one day into the payroll period and quits, they could easily have the employer covering for them, but someone that quits on the last day of the payroll period, most likely will have all of it come out of their paycheck.

There is something wrong with this differential application, in my opinion.

[Guest AnExDelphiEmployee]

As an employee, I experienced this, and successfully sued in small claims for the "negative balance" that was withheld from paycheck at termination. The employer plan could not demonstrate suitable risk-shifting to the court because they pocket the unused FSA contributions of employees at the end of the year, even though they have a clause that would have allowed me to continue to use the FSA after termination.

In my case, my new employer plan (And my interpretation of the IRS rules of the new plan) also did not allow such reimbursement.

My facts: Elected $5000 into FSA for the year. Terminated employment in June. Employer (illegally) withheld ~$2700 from my last paycheck. I had used most (but not all) of the $5000 for FSA medical expenses. Court awarded the ~$2700 and costs.

Small claims is a somewhat painful way to recover the funds (two days lost), I went prepared with

this thread,

a highlighted copy of http://www.indstate.edu/humres/docs/Section125-2.pdf (Page 6 Example 2)

http://en.wikipedia.org/wiki/Flexible_spending_account/

Formal letters and emails exchanged with HR

Paystub