Health care flexible spending accounts ("FSAs") established pursuant to a cafeteria plan under Section 125 of the Internal Revenue Code of 1986, as amended, have long permitted employees to make pre-tax salary contributions to an account in order to receive reimbursements to pay for certain qualifying medical benefits that are not reimbursed through insurance or another arrangement. In order to participate in an FSA, an employee must elect in advance of the plan year the amount of pre-tax pay that he or she wants to use for that year, and amounts that remain unused at the end of a plan year must be forfeited. This so-called "use-or-lose" rule, although based on other related tax law principles, has been criticized by many as forcing employees to make guesses about their future level of use of their FSAs, and the rules arguably push participants into incurring expenses at year end simply to avoid forfeiting funds. The impact of the "use-or-lose" rule was somewhat lessened in 2005 by Internal Revenue Service ("IRS") Notice 2005-42, which allows a plan to include provisions that provide for reimbursement of certain qualifying medical expenses incurred during a 2½-month grace period following the end of the plan year. Any amount not used by the end of the grace period would still be subject to forfeiture.

Then, in connection with the Patient Protection and Affordable Care Act's imposition of a $2,500 (indexed for cost-of-living adjustments) limit on employee salary reduction contributions to health FSAs (effective for plan years beginning in 2013), in Notice 2012-40, the Treasury Department and IRS sought comments as to whether the "use-or-lose" rule should be modified. On October 31, 2013, the Treasury Department and the IRS issued Notice 2013-71, which provides plan sponsors with flexibility in plan design with regard to the "use-or-lose" rule as well as additional clarifications regarding salary reduction elections for non-calendar year cafeteria plans.

Under the new guidance, Section 125 cafeteria plans can be, but are not required to be, amended to allow up to a maximum of $500 of unused amounts remaining at the end of a plan year in a participant's FSA to be carried over to the next plan year and used to reimburse the plan participant for qualified medical expenses incurred during the immediately following plan year so long as the plan does not also use the grace period rule. An employer will have to choose which of the two rules, grace period or carry-over, it wishes to include in its cafeteria plan, although neither rule is required.

This carryover can apply to the entire plan year to which it is carried and will not affect the $2,500 cap on salary reduction contributions that the participant is otherwise eligible to elect for the new plan year. For administrative ease, Notice 2013-71 provides that the cafeteria plan can use a "first in, first out" approach and treat reimbursements of all claims for expenses that are incurred in the current plan year as reimbursed first from unused amounts credited for the current plan year and, then, after using such amounts, as reimbursed from unused amounts carried over from the preceding plan year.

Plans that wish to use the carryover approach under Notice 2013-71 must be amended to provide for the carryover provisions and, if applicable, eliminate the grace period rule provisions. The amendments must be adopted on or before the last day of the plan year from which amounts may be carried over and can be effective retroactively to the first day of that year, provided that the plan is operated in accordance with the guidance in Notice 2013-71 and participants are informed of the new provisions. Notice 2013-71 further provides that a plan may be amended to adopt the carryover provision for a plan year that begins in 2013 at any time on or before the last day of the plan year that begins in 2014. Coordination of these requirements may make it difficult to take advantage of these design options until proper planning can be undertaken and communicated to participants. The Treasury Department and IRS also intend to amend the proposed cafeteria plan regulations under Prop. Treas. Reg. Sections 1.125-1(o) and 1.125-5(c) to reflect the guidance in Notice 2013-71, and taxpayers may rely on the guidance in Notice 2013-71 until such amended regulations are effective.

It is worth noting that Notice 2013-71 also clarifies the scope of the transition relief that was set forth in the preamble to the proposed regulations on the employer shared responsibility provisions under the Patient Protection and Affordable Care Act with regard to changes in elections for non-calendar year plans. Under the clarification, non-calendar year cafeteria plans can be amended to allow employees to make a mid-year change to their elections so that they may, for example, cease coverage under the employer plan and purchase coverage in the Health Insurance Marketplace, regardless of whether the employer is a small or large employer.

Many participants and employers have, for a long time, criticized the "use-or-lose" requirement as being far too rigid. For many employees, even relatively small forfeitures posed a hardship. Although some would certainly have preferred to see the "use-or-lose" rule completely repealed, Notice 2013-71 should nonetheless provide a bit of welcome relief to critics of the rule and provide employers with planning opportunities for their cafeteria plan designs.

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