Small Business Taxes & ManagementTM--Copyright 2013, A/N Group, Inc.
A cafeteria plan is a written plan maintained by an employer under which all participants are employees and all participants may choose among two or more benefits consisting of cash and qualified benefits. A qualified benefit is one that, with the application of Section 125(a) is not includable in the employee's gross income as a result of an explicit provision in the law. Qualified benefits include employer-provided accident and health plans excludable from gross income under Sections 106 and 105(b)(as are dependent care assistance, adoption assistance, etc.), but exclude long term care insurance and certain qualified health plans offered through an Exchange (Marketplace) established under section 1311 of the Patient Protection and Affordable Care Act.
Example--Madison Inc. has a cafeteria plan. While Fred is covered by the company's health insurance plan, he has to contribute $250 a month as his share of the premiums. Madison's cafeteria plan allows Fred to elect to receive cash (i.e., his regular salary) or reduce his salary by up to $2,500 with the funds to be used to pay his portion of the health insurance premiums. If Fred elects to make the insurance payment through the cafeteria plan, the amount ($2,500) is not includable in his gross pay and not subject to income, social security, or medicare taxes.Use of a cafeteria plan can not only save taxes on the income not reported on his W-2, it may reduce a taxpayer's AGI enough to avoid the phaseout of some benefits such as the child credit, education credits, etc.
A flexible spending account (FSA) can be part of a cafeteria plan if an employer provides for that benefit in the cafeteria plan's document. An FSA can be used to pay for other medical expenses such as a insurance co-pays for doctor visits and drugs, dental work, drugs prescribed by a doctor but not covered by insurance, etc. The employee is reimbursed by the employer for his out-of-pocket expenses based on receipts or similar documentation submitted to the employer or administrator.
For years after December 31, 2012, the maximum salary reduction for an FSA is limited to $2,500 (indexed for inflation after 2013). Any amount not used during the year is lost. For example, in late 2012 Fred elects to "fund" his FSA for $2,500 for 2013. However, at the end of 2013 there is still $375 unused in his FSA. That amount is permanently lost. Any amount in the plan not used at the time of the employee's termination is generally also forfeited.
An employer can draft a plan that would allow a grace period of 2-1/2 months. For example, if, in the example above, Fred managed to spend the money on dental care before March 15, 2014, he could use the unused $375 from 2013. Not all plans contain this provision. Whether or not it's included is up to the employer. In addition, the plan may include a "run-out period" where expenses incurred for a plan year are not reimbursed until the following year because claims filed near the end of the year cannot be processed before the end of the year.
In Notice 2013-71 the IRS has added another option. This option (carryover option) allows cafeteria plans to be amended to allow up to $500 of unused amounts remaining at the end of the plan year in a health FSA to be paid or reimbursed to plan participants for qualified medical expenses incurred during the following plan year, provided that the plan does not also incorporate the grace period rule. The plan may, however, contain a run-out period provision.
If your business has a health FSA you may want to modify the written document to include this new carryover rule. The plan is not required to have a grace period or a carryover period. Thus, the plan can be written to have no grace or carryover period, a grace period of 2-1/2 months, or a carryover period with the carryover amount limited to $500. The plan cannot contain both a grace and a carryover period. Under any of these three options a run-out period is permitted and the maximum amount that can be deferred for a plan year is $2,500 (indexed for inflation).
What's the best option? It's likely most employees would prefer the carryover provision. By it's very nature it provides for a "grace period" of up to $500. And, for most employees that should allow for miscalculations in usage. It also means an employee who wants to use $300 for dental work doesn't have to do it within 2-1/2 months of year end.
Keep in mind that there's more to an FSA than discussed above and if you don't currently have a plan you'll need a written document. For further information and examples on the carryover provision go to www.irs.gov/pub/irs-drop/n-13-71.pdf.
Copyright 2013 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 11/15/13