Section 125 / Cafeteria Plan Forfeitures

[Guest sgb]

I received some mixed information regarding the appropriate use of participant forfeitures in a section 125 plan.

I understand that forfeitures can be used to offset administrative expenses or to reallocate dollars back to plan participants.

However, I'm not clear on whether the forfeitures may be used to reduce payment of future claims. For example, can we use last years forfeitures as a deposit in this years Flex account and reallocate participant payroll deductions ?

What do most organizations do?

I've been searching for Proposed Reg 1.125-2 Q&A 7 that is mentioned in Question 60 of the Section 125 Q&A that on this site but I'm having trouble finding it.

Any input is appreciated.

[papogi]

Reg 1.125-2 (Q7)(B)(7) states, "Alternatively, the $5,000 [in the IRS example] may be used to reduce the required premiums under the health FSA for all eligible employees for the next plan year (e.g., a $500 health FSA for the next year might be priced at $480) or to reimburse claims incurred above the elective limit in such year as long as such reimbursements are made in a nondiscriminatory manner."

I would recommend just a basic dividend or premium refund. It seems that what you are proposing is allowed, but it can raise complications in dealing with employees and their elections. For example, using the amount to raise the the reimbursable amount will only work if the employee comes up with enough extra claims to actually get the money out. Also, using the money to partially fund the employee's next year election will, in essence, lower the payroll deductions the employee intended or agreed to. While most employees welcome lower payroll deductions, there might be some reason the employee elected a certain amount in order to reduce his/her taxable income to a certain level.

[Guest Laura Browne]

How is your plan document written to handle forfeitures? If it's written to give the excess back per capita, you cannot use it for administrative or any other expenses.

[papogi]

Yes, if it's specified in the plan doc, then you'll need to follow that. Good point. Experience gains do not have to be addressed in plan docs, however, so you may not find anything in there. As long as it is handled in a nondiscriminatory manner, you can do one thing one year, then something else the next year.

[Guest sgb]

We do not address experience gains in our plan document.

Is it allowable to hold experience gains in an account to fund losses in a future year?

[papogi]

The premium refund, or however you choose to disburse the funds, should be done within the plan year following the year the experience gain occurred. Otherwise, you may run into a deferred compensation issue [1.125-2 (Q5)(a)].

[Guest aearle]

Is it correct that the employer can use the leftover money (forfeitures) any way they see fit, including buying office furniture, throwing a holiday party, etc.? That is what I have been told (that the IRS does not care what the employer does with the leftover money). Thanks!

[papogi]

You will hear differing opinions on this point at this message board. My opinion is that experience gains (forfeitures minus losses and admin costs) go into the general assets of the employer. Theoretically, they can be used in any way the employer wishes, as long as nothing directly contradicts the small list of specifically allowable options under 1.125-2 (Q7)(B)(7).

[IRC401]

Isn't 1.125-2 Q&A7 still a proposed reg. ?

[papogi]

Yes, it is. It's all we have to go on, so I think a good faith effort to administer a 125 plan would include looking at and following rules within 1.125-2. Incidentally, you can find the provisions outlining the uniform reimbursement requirement of HCFSA's, the 12 month period of coverage rule, and the rules surrounding claims substantiation within 1.125-2. These rules are almost invariably followed, so I would hesitate calling 1.125-2 merely "proposed" when it comes to real world application (even though you are correct that they are technically only proposed regulations).

[Guest aearle]

Thanks! Also, if the employer does actually lose money (the payouts exceed the "leftovers"), is this loss a tax write off? I assume that it is not because the IRS has structured the benefit to have just as much of a chance of a gain as a loss, so there are not tax implications either way for the employer, but....

[papogi]

I think your reasoning is correct that there are no tax implications, but I am not certain (corporate tax law is not my specialty). Hopefully someone else can confirm...