QUESTION: We inadvertently allowed an employee to make health FSA salary reductions that exceed the Code’s limit. Will this cause our cafeteria plan to lose its tax-advantaged status?
ANSWER: The general rule is that a cafeteria plan will lose its tax-advantaged status if it fails to comply with the annual limit on health FSA salary reductions ($2,750 for plan years beginning in 2020 or 2021). However, the tax-advantaged status of a plan that has been timely amended to comply with the limit will not be lost solely because one or more employees are inadvertently allowed to elect salary reductions in excess of the limit, so long as all of the following requirements are met:
The plan’s terms apply uniformly to all participants (as required under IRS cafeteria plan regulations);
The error results from a reasonable mistake by the employer or its agent (e.g., a TPA); and
The error is timely corrected.
For purposes of the last requirement, salary reductions in excess of the limit must be paid to the employee and reported as wages for federal income tax withholding and employment tax purposes on the employee’s Form W-2. Calendar-year plans must report the excess on the Form W-2 for the year in which the correction was made; non-calendar-year plans must determine the plan year in which the correction was made and report the excess on the Form W-2 for the year in which that plan year ends.
For example, assume that an employee elected health FSA salary reductions of $2,750 for 2020 under a calendar-year plan that was timely amended for the limit. Due to an administrative error, however, her actual salary reductions reached $2,850 after the first pay period in December 2020. The mistake was discovered at that time and was corrected by refunding the $100 excess salary reductions, less income tax withholding and employment taxes, by December 31, 2020. The excess was reported as wages for income tax withholding and employment tax purposes on the employee’s Form W-2 for 2020 (issued in 2021). Under these circumstances, the excess health FSA salary reductions will not cause the cafeteria plan to lose its tax-advantaged status, assuming the other requirements of the relief are met. The same would be true if the mistake were not discovered until April 2021, provided that the excess is refunded by December 31, 2021, and reported on the employee’s Form W-2 for 2021 (issued in 2022).
Note that this relief is not available for employers whose federal tax returns are under examination with respect to cafeteria plan benefits for any cafeteria plan year in which there was a failure to comply with the limit on health FSA salary reductions. For this purpose, a tax return is treated as being under examination if the employer has received written notification from an examining agent that cites Code § 125(i) (the Code section that provides for the limit) as an issue under consideration.
For more information, see EBIA’s Cafeteria Plans manual at Section XIX.F.8 (“Limitation on Health FSA Salary Reductions: Correction of Excess Contributions”). You may also be interested in our webinar “Common Mistakes and How to Fix Them: Cafeteria Plans, Health FSAs, and DCAPs” (recorded 7/22/2021).
Contributing Editors: EBIA Staff.