Use of FSA rollover if not contributing in subsequent year?

Client has FSA that allows rollover of unused FSA balance up to IRS maximum.  Plan year is 7/1 - 6/30.  For 2023 PY, employee had unused funds that rolled over 7/1/24; however, employee did not elect to make contributions for 2024 PY (and there are no employer contributions to the FSA).  Can the employee use the rollover from 2023 PY for expenses incurred in 2024 PY?  My initial reaction is the employee is not a participant in the FSA for the 2024 PY so they cannot submit for reimbursement of expenses in 2024 PY.  Do we treat the employee similar to a terminated employee and allow a run-out period to spend down their rollover balance?  Any thoughts (as citation to official guidance, etc.) are appreciated!

This is a plan design question.  The default position is that the carryover from year one is available in year two regardless of whether the employee makes a year two election.  However, the cafeteria plan can specify that the carryover is available only for employees who make a year two election.  So you'll have to check the Section 125 cafeteria plan doc to confirm.

Here's the overview--

https://www.newfront.com/blog/health-fsa-500-carryover-conditioned-on-new-plan-year-election-2

Default Rule: Access to Health FSA Carryover Regardless of Subsequent Plan Year Election

For health FSAs that offer the $500 carryover, the default position is the employee will continue to have access to the carryover amount in subsequent plan years regardless of whether the employee elects to contribute to the health FSA again in the subsequent plan year.

Where the employee does not elect to contribute to the health FSA for the subsequent plan year, the employee would have access to only the carryover amount under the health FSA for the subsequent plan year.

...

Plan Terms May Condition Carryover On Subsequent Plan Year Health FSA Election

The plan may restrict carryover funds to only those employees who elect to contribute for the subsequent year.  The plan terms may therefore provide that employees must make a minimum election of some amount (e.g., $100) to the health FSA for the subsequent plan year in order to participate and have access to the up to $500 carryover from the prior year.

In this situation, employees who do not make the minimum election to participate in the health FSA for the subsequent year will forfeit any unused amount at the end of the plan year and any associated run-out period.  In other words, there will not be any carryover amount available in the subsequent plan year.

...

IRS Notice 2015-87:

https://www.irs.gov/pub/irs-drop/n-15-87.pdf

Question 24: May a health FSA condition the ability to carry over unused amounts on participation in the health FSA in the next year?

Answer 24: Yes. A health FSA may limit the availability of the carryover of unused amounts (subject to the $500 limit) to individuals who have elected to participate in the health FSA in the next year, even if the ability to participate in that next year requires a minimum salary reduction election to the health FSA for that next year.

Example. Facts: Employer sponsors a cafeteria plan offering a health FSA that permits up to $500 of unused health FSA amounts to be carried over to the next year in compliance with Notice 2013-71, but only if the employee participates in the health FSA during that next year. To participate in the health FSA, an employee must contribute a minimum of $60 ($5 per calendar month). As of December 31, 2016, Employee A and Employee B each have $25 remaining in their health FSA. Employee A elects to participate in the health FSA for 2017, making a $600 salary reduction election. Employee B elects not to participate in the health FSA for 2015. Employee A has $25 carried over to the health FSA for 2017, resulting in $625 available in the health FSA. Employee B forfeits the $25 as of December 31, 2016 and has no funds available in the health FSA thereafter.

Conclusion: This arrangement is a permissible health FSA carryover feature under Notice 2013-71.

Thanks - This is extremely helpful!