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IRS Issues Guidance on Health FSA Carryovers
Flexible spending account (FSA) carryovers prevent funding of a health savings account

By Edward I. Leeds, © Ballard Spahr LLP  4/7/2014

The IRS has issued guidance on two issues affecting health flexible spending arrangements (health FSAs). The first provides guidance on how a health FSA that consists solely of amounts carried forward from the prior year (through rules issued last fall that allow up to $500 to be carried forward) may be coordinated with coverage under a health savings account (HSA). The second addresses correction procedures for improper health FSA payments.

In Memorandum 201413005, the IRS confirms that an employee may not contribute to an HSA if he or she is covered under a general purpose health FSA, even if that FSA contains only amounts that are carried forward from the prior year. This applies for the entire year, even after the amount carried over is spent.

Individuals are generally prohibited from contributing to an HSA unless they participate in a high-deductible health plan and do not participate in any other health plan that provides coverage for deductibles, co-payments, and other expenses that are covered under the high-deductible plan. A general purpose health FSA would cover those expenses.

The memorandum describes a few options that employers may pursue if they have added carry forward provisions to their health FSAs and are concerned about the limits this might impose on an employee who wishes to enroll in a high-deductible health plan with an HSA in the following year. These options include:

  • Providing for the carry forward to be applied to a limited-purpose health FSA (such as for dental and vision services exclusively) that is compatible with an HSA.

  • Allowing employees to elect not to carry forward any unused amounts from their health FSA if they are going to enroll in an HSA.

Correcting Reimbursement Errors

In Memorandum 201413006, the IRS provides that employers may correct improper health FSA payments by using the same methods that apply under guidance for unsubstantiated payments when a health FSA uses a debit card. The details of this guidance, included in proposed regulation 1.125-6(d), are highlighted here. These correction mechanisms include:

  • Demanding payment.

  • Withholding amounts from the employee's pay, to the extent permitted under applicable law.

  • Offsetting the amount owed by the employee against other health FSA payments.

The guidance makes it clear that an employer may apply these remedies in any order as long as it follows that order consistently. The employer should seek to recover the overpayment in the same year it is made. If the employer tries all of the methods for recovery and still does not successfully recover all of the improper payments, the employer may treat the amount as business indebtedness and report it as taxable income to the employee on a Form W-2.

Edward I. Leeds, counsel at Ballard Spahr LLP, concentrates on issues relating to the design, administration, and taxation of health and other welfare benefits plans. © 2014 Ballard Spahr LLP. All rights reserved. Reposted with permission.

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