FSA Grace Period for Terminated Employee

[Guest RGH2]

Assume a typical health care FSA arrangement in a Section 125 plan with a calendar year plan year. Assume further that an employee (1) has a positive balance remaining in his FSA on December 31, and (2) terminates his employment with the plan sponsor on that day.

Can this terminated employee take advantage of the grace period (incurring new qualifiying expenses to be reimbursed by his FSA account) without having to elect COBRA?

I have argued that this terminated employee CAN use the grace period without electing COBRA. My rationale is that (A) this employee has already made the maximum contribution to his FSA, (B) the purpose of the 2 1/2 month grace period is to provide some limited relief from the "use it or lose it" rule for the benefit period covered by the FSA, and © requiring a participant to stay employed with the plan sponsor beyond that benefit period (or even, if still employed, to continue actively contributing to a new FSA for the new plan year) doesn't really further that purpose.

Unfortunately, I have not yet located any clear authority (or even a directly on-point discussion on this Board) to support my conclusion. We had a rather spriited philosophical debate about this in a plan restatement drafting session the other day, so I would love to come up with good authority or at least a more convincing rationale.

We understand that we would want to be sure that the plan's definition of "participant" is broad enough so as not to inadvertently tip the scales one way or another.

Thanks for your input.

[Guest RGH2]

The authority I was looking for was right before my eyes, or at least in my dog-eared and highlighted copy of the 2007 proposed regs. See Prop. Regs. section 1.125-1(e)(3)(i), as well as Example 3 under section 1.125-1(e)(4). So I can't take credit for my analyis, but at least I now know why I was so convinced I had the right answer, and where I had seen it before.