End of Plan Year Change in Status

[Guest ehs]

A participant experiences a life event (birth of a child) and wishes to increase his health FSA election in the plan year in which the event occurred. The child was born 6/17, but the participant did not notify the employer until after the last payroll had run for the plan year that he wished to make an election change (but before the end of the plan year). Now the plan year has ended (6/30) and the employee wants the change to happen. The change should be honored, but how does the employer collect the funds?

[LRDG]

Amend the final pay check to account for the medical FSA election increase and the reduced tax withholdings.

[QDROphile]

What about the requirement that salary reduction can be effected only prospectively, never mind when the qualifying event occurs?

[LRDG]

IRS regs do state the plan must opperate Sec. 125 payroll reductions on a prospective basis only.

[Guest ehs]

So, even if the plan year has closed, the employer could deduct the election change out of a new plan year for the old plan year? One payroll deduction?

[QDROphile]

No.

[LRDG]

FSA claims must include service dates no later than the last date of the plan year.

My suggestion to ammend the final paycheck to cover the election change does not cause the entire plan to opperate in a manner that allows funding on a retro-active basis.

At the time wording was formerly added to the regs requiring plan operate in a mannter that required FSA payroll reductions on a prospective basis, there was a large case with a few thousand EEs who's elections were set up for payroll deduction several months after the effective date of the plan and of course after open enrollment was completed. The payroll system had to be re-programed to allow pr-tax deductions, a problem that was not unheard of at that time.

However the plan had other major compliance issues, such as violation of constructive receipt. Large sanctions and penalties were assessed and the case made the WSJ among other news publicatons. None of the compliance problems or penalties had any baring on the prospective basis language that was added to the regs.

Based on my experience, amending the final paycheck to cover the increased election amount before the plan year ends, does not cause the plan to opperate in a manner that allows retrospective/retroactive payroll reductions.

[J Simmons]

LRDG,

There are two possible retro scenarios. One is where the mid-year increase was elected before the last payroll, but due to payroll failure it was not implemented. Later, that final plan year payroll is corrected. That I could easily see as not violating the rule against retro elections.

The other possibility is where as the OP posits the mid-year increase was not elected until after the last payroll of the plan year had already run. The employee had full access to the payroll money in question before making the election. Having full power over those dollars, he is taxable on them. A cafeteria plan is an exception to the constructive receipt doctrine. One of the reasons that cafeteria plan elections must be made in advance of the money becoming available is so that the constructive receipt doctrine is left intact (or mostly so).

I guess my question is whether your experience has been of the first type I mention or more of the second type, which is what the OP is, and if the second type, in your experience has the IRS known about and either approved or simply ignored the retro election?

[GBurns]

I see two separate issues, funding and the incurring of expenses.

While it might be permissible to make the payroll change to accomodate the salary reduction, there still is the issueof using the money.

The child was born 6/17 and the notificaton/plan change date would be 6/18 at the earliest. When were the eligible expenses incurred.

The FSA cannot reimburse expenses incurred before plan change effective date.

In any case, Is there enough money involved to warrant the effort to correct?

[LRDG]

J Simmons, there has not been much Sec. 125 audit activity. The reason may have to do with some of the issues posted here, such as the temporary status, and proposed regs.

The good news is there's minimal case history on which to rely because there have not been many Sec. 125 audits. If and when this changes, I think we'll hear about it because there'll probably be a lot of coverage, in trade and financial publications.

To prohibit the status and election change in this circumstance because the participant's family status change happened so close to the end of the plan year penalized the participant for reasons out of their control. The plan has a qualified status change request from the participant, but a plan that won't allow the election change.

I agree that this could be a violation of constructive receipt if the circumstances were slightly different, if there was a failure on the part of the participant or intent to unfairly enhance conpensation. The primary problem is the date of birth being so close to the end of the plan year.

The participant has the expectation that birth of the child is a qualifying event and that an election change will be permitted. That an unwritten penality is applied because the participant's child is born too close to the final pay day and end of the plan year is unfair to this and other participants in this same situation.

Payroll frequency and schedule is at the convenience and control of the employer, not within the control of the participant. The date of the qualifying event is also not within the participant's control. One of the underlying principals established by the IRS for evaluating family status changes was the principal that events not be within the participants control.

[J Simmons]

My problem with the retro election in this scenario is the dominion that the employee has over the dollars in question. Once the paychecks are cut and delivered, albeit for the last payday of the plan year, the employees can do with that money whatever they will. The employee in question could choose to do nothing with respect to the flex account by reason of the 6/17 born child, and instead buy a big-screen TV.

On the other hand, the employee could, as here, try to squeeze dollars already in his pocket back into the tax-free flex account. Once the paycheck was cut and delivered, we'd not be dealing with the more theoretical 'constructive receipt', but the more palpable actual receipt for income tax purposes. The change in status rules are exceptions to the specific year-long election rules, not to the more basic and general tax rules that require the election be in advance of constructive receipt.

[LRDG]

I don't understand how the EE is enriched to the extent that would involve a large screen tv. Can you explain it because I'm curious how you anticipate making adjusts.

I'll assume the last paycheck has been issued and that the FSA election increase is $500.

Withholding tax savings on $500 is for example purposes, 25% or $125.

EE must fund the FSA since funding can't be accomplished with a payroll reduction. After payroll records are adjusted, the EE will write a check for $500 to fund the FSA. Instead of the ER cutting anouther check for $125 to refund taxes withheld on the FSA increase of $500, the EE can adjust his personal check and instead write it for $375 to account for the tax refund. The EE is not 'enriched' untill the FSA claim is paid, in fact since he funded the FSA with a personal check, he has less cash initially.

[J Simmons]

On your posited numbers, the windfall would be $125 in tax savings--for expenses he knows he's already incurred by the time he attempts to retro. It's a big problem that the money is in the EE's pocket by the time he'd be making the 'election'.

[LRDG]

If IRS audited the plan after adjustmentent of payroll records to allow the election change, IRS would recognize that the employee would otherwise be allowed a standard 30 days to make an election change. But for the 2 or 9 days (depending on date of the final payroll 6/20 or 6/27), from the date of birth in relation to the last payday and 12 days to the end of plan year, this transaction would be no different than any other status change.

[Guest ehs]

So, if I understand the many responses, one issue relates to a retroactive election. If the employee is intending to elect for expenses that were associated with the birth, which would presumably be before the election, then they are not eligible?

Secondly, if the election is permitted (for expenses as of the formal election) then am I understanding that the funding of the election is with post-tax dollars? So, there is no financial benefit to the participant by making an election change, correct?

[Guest Ham Porter]

"The child was born 6/17 and the notificaton/plan change date would be 6/18 at the earliest. When were the eligible expenses incurred."

Based on this statement what would be the period of coverage for eligible expenses for the Healthcare FSA? Assuming a Calendar Plan Year if the DOB is 6/17 but the participant did not increase their contribution to their Healthcare FSA account until 6/30 then what would be the period of coverage? Would any expenses incurred 6/18 thru 12/31 be eligible or 6/30 thru 12/31? Just curious.

[LRDG]

The dates incurred would run from the date of birth through the last day of the plan year, or 06/17/08 through 06/30/08.

We can assume there are EOBs involved dated from the date of birth, assume a minimum 24hr, maximum 3 day hospital stay, or 72hrs, would leave us with a discharge date of the 20th. Probably a new born and new mommy visit 3-6 days days followng discharge or 06/26/08. Everything else in the new plan year. Purely hypothetical, but you get the idea, I don't have any first hand experience, but based on EOBs I've seen, shortened hosiptal stays covered in the media, my adopted daughter's hospital stay, I think the timeline and dates are reasonable.