FSA One time election of full yearly amount

[Guest planwizard]

I hope this is a simple question for you 125 Gurus.

A plan (FSA) allows, but does not require an individual to "pre-pay" her entire annual election. Say, for example, the plan allows a maximum election of $5000. The "premium" may be paid in one payment, out of the first plan year pay or in installments, regular or scheduled (e.g. monthly pay [$5000/12], or, by way of further example, One in January and one in July. Another option, for purposes of discussion might be in 6 installments-Jan through June, and then stop. Conceptually, I think any of therse payment options will work. However, I'm a little troubled with the one time up-front payment. Her is why. Reg 1-125-2 says the following:

A health FSA will not qualify for tax-favored treatment under Sections 105 and 106 of the Code if the effect of the reimbursement arrangement eliminates all, or substantially all, risk of loss to the employer maintaining the plan or other insurer.

Does anyone else think that the one time payment option, at least when it is only offered at the beginning of the year, runs afoul of this proscription?

[papogi]

Yes, I do. Prop. Treas. Reg 1.125-2 has examples that indirectly address this [A-7 (b)(2) and (3)]. In cases like this, the employer should return a prorated amount back to the terminated participant. Otherwise, the employer has removed too much risk for there to be true risk-sharing. If, however, the employer's plan calls for terminated participants to have access to their FSAs up to the end of the plan year (since they paid the premium for the entire year up front), then it could be argued that the employer is OK. It's a "no-no" for the employer to keep the annual premium yet terminate the FSA mid-year. It's a "maybe" if the employer keeps the annual premium but allows terminated participants to access the FSA up to the end of the plan year. It's definitely OK if the employer returns a prorated amount back to terminated participants.