More on Uniform Coverage in an FSA

[Guest Maggie6561]

OK, now I've gotten pointed to the IRS regs making it clear that an employee may leave having been reimbursed more than was withheld for their medical FSA. So next question:

If an employee terminates with a negative balance in their FSA, i.e. having been reimbursed more than they had withheld, is the amount of "overage" a taxable fringe benefit to that employee? If so, is it reported on the W2?

[Guest b2kates]

No, remember that the FSA is essentially a medical plan under Section 105 of the Code and benefits received are, if not discriminatory under 105(h) are income tax free.

[Guest Maggie6561]

No, remember that the FSA is essentially a medical plan under Section 105 of the Code and benefits received are, if not discriminatory under 105(h) are income tax free.

Brett - So I would cite Section 105 (I've lloked it over and it seems to answer the question) to my boss as the reason why we don't issue a 1099 or include the amount on the W2? What are the potential repercussions to the company if the boss insists on issuing a 1099 or W2? He thinks its "ridiculous" that this wouldn't be taxable. How do I answer???

[QDROphile]

Lets look at the dark side for a moment. Your boss is unhappy about the experience loss (paying more in benefits than was covered by salary reduction), so now the boss wants some consolation that the former employee will at least feel the pain of taxes. He must be a peach to work for.

If your boss would free his mind from his emotional prison for a moment, it might help to understand how FSAs work. As far as the tax code is concerned, the employer does not use the employee's pay to cover medical expenses, so there is no connection between the cost to the employee and the value of the benefit. This view from the tax code is not intuitive, so I have some sympathey for the boss. The employer promises a certain level of health payments. That level is chosed by the employee, subject to the maximum established by the employer in the plan. The employer is functioning like an insurance company -- it promises benefits.

In exchange for the benefits, the employee agrees to a salary reduction -- the employee chooses benefits over cash compensation. If the employee terminates before the full amount of salary reduction is collected, that does not affect the employer's promise to pay benefits. Or, you could look at the salary reduction as the employee's premium for the benefits that the employer (as insurance company) provides. Insurance companies don't collect premiums equal to benefits. They have to provide the promised benefits whether or not the value of benefits exceeds the premium. The difference does not make anything taxable. Employer provided health benefits are not taxed.

You could have a plan that provides the FSA benefit with no reduction in salary by the employee. Still not taxable. The cost to the employee has nothing to do with the taxability of benefits.

I have not checked the penalties for a deliberate misreporting of income, but that is what it would be. Since correct reporting is the heart of the system, I expect that a deliberate misstatement would have adverse consequences. And it would be very easy for the IRS to conclude that the misreporting was deliberate, given the apparent hostility your boss has shown to life under sectons 125 and 105. Also, since the former employee has a great interest in not paying taxes on nontaxable amounts, you have direct and certain oppositon to bring the issue to the attention of the IRS, if only as self defense. How big a deal it becomes is uncertain. At a minimum, you can expect some effort to reconcile the employer's position and the taxpayer's positon. Is it worth the potential follow-up distraction to make one last dig at the former employee?