Benefits Alerts

July 11, 2005

Adopting the New Grace Period: Not as Simple as it Looks

In Notice 2005-42, the IRS announced that cafeteria plans can reimburse participants for claims incurred during the 2½ months following the close of a plan year. Previously, the cafeteria plan rules required that expenses reimbursed through a cafeteria plan’s reimbursement features (e.g., health reimbursement accounts and dependent care reimbursement accounts) be incurred during the plan year in order to be reimbursable and that any amount of benefits remaining upon reimbursement of claims incurred during the plan year be forfeited (i.e., the “use it or lose it rule”). The Treasury press release announcing this development can be found at http://www.treas.gov/press/releases/js2456.htm and includes a link to the official guidance, IRS Notice 2005-42.

Taking advantage of the grace period authorized by IRS Notice 2005-42 is not as simple as it looks. A plan sponsor must consider the following:

1. Objectives of the grace period and designing the amendment to meet those objects;
2. Impact on related programs and obligations;
3. Vendor’s ability to administer; and
4. Documentation of the change.

Plan Sponsor’s Responsibility
The Notice authorizes the adoption of an amendment to the health reimbursement and dependent care reimbursement component features of the employer sponsored cafeteria plan. Amendment of the plan is accomplished by the plan sponsor. Because the Notice “permits” the plan sponsor to provide a grace period of up to 2½ months, there is a considerable amount of discretion. The plan sponsor needs to determine (1) whether to adopt the grace period, and (2) the details of such an amendment. The details of the amendment include things such as:

• Whether to adopt it for the current year or to wait until the start of the next full plan year;
• Whether to adopt the full 2½ months or something less;
• Whether to adjust the current run out period of the plan;
• Whether to permit access of the entire remaining balance or a lesser amount (e.g., maximum $500);
• Whether the grace period applies to health reimbursement and/or dependent care reimbursement; and
• Whether to allow participants to opt out of the grace period (to the extent permitted by law).

Caution: Some of these decisions will already be made for you by your vendors (e.g., third party administrator).

More on Design Choices
There are a number of items the plan sponsor should consider (1) before deciding whether to adopt the amendment, and (2) in designing the amendment if adopted.

Length of Grace Period
The 2½ months allowed by the Notice is the maximum grace period the plan may allow. A plan sponsor could choose to provide a shorter grace period.

Length of Run Out Period
In many cases, the claims run out period (i.e., the period of time following the plan year in which claims incurred during the plan year must be submitted for reimbursement) will have to be adjusted if the grace period is adopted because the current run out period may expire prior to the conclusion of the grace period. Consideration must also be given to the length of the run out period following the grace period.

Accessibility
The plan sponsor could put a limit upon the amount of the account accessible for claims incurred during the grace period (e.g., $500). What could be reimbursed could also be limited (e.g., no lasik or orthodontia; just prescription drugs).

Health Reimbursement and/or Dependent Care Reimbursement
The grace period could be limited to a particular component of the cafeteria plan, or could apply to all reimbursement components.

Opt Out – HSA Eligibility
In order to be eligible for an HSA contribution, a person generally may not have “other” coverage. In most cases, being covered by a health FSA is considered “other” coverage thereby rendering the HSA owner ineligible for a contribution. Especially for employers planning to transition to an HSA as of the next plan year start adding the extended grace period may prevent a complete conversion. Because the clarification requires application of the grace period to all participants, those transitioning to (i.e., electing) an HSA would not be able to contribute to an HSA until the first day of the third month (i.e., first day of the month following expiration of the grace period.) Therefore, the plan sponsor may want to provide participants the ability to opt out of the grace period so they will not have other coverage following the close of the current plan year.

Related Issues
Adoption of the grace period impacts other employer obligations, such as the following:

Ordering
Reimbursement plans do not operate in a vacuum. There are a number of “ordering” issues to consider within a particular plan and between different plans of the employer.

Within Plan - Claims incurred during the grace period will be deemed to have been incurred in two plan years – the prior plan year to which the grace period applies and the current plan year. For those participants participating in the plan during both years, the plan document must address from which year’s benefits such claims are paid. Presumably, claims incurred during the grace period will first be reimbursed from the prior year’s account balance and, once that balance has been exhausted, from the balance of the current year’s account.

Between Plans - Normally, an employer that sponsors a health FSA and a health reimbursement arrangement (HRA) must, by plan design, dictate which of the two plans pays first. To the extent the health FSA has a grace period, the ordering language needs to be reviewed. And, it may need to be adjusted to reflect both health FSA accounts. For example:

The plan document provides the HRA pays second to the health FSA. The health FSA now provides for a 2½ month grace period. This means an expense may be eligible for reimbursement from three places. An expense incurred during the grace period could be reimbursed from the previous plan year’s health FSA remaining balance, the current year’s health FSA account, or the HRA. If the HRA pays second, both health FSA account balances must be exhausted first.

Nondiscrimination Testing
It is not clear how the nondiscrimination testing under Section 105(h) of the Code for health FSAs should reflect grace period expenses. For example, to what year are they attributable, year one, year two, the year in which an expense is actually reimbursed, the year of the account from which the expense is reimbursed? Similar issues arise with respect to dependent care expenses. Also, with respect to dependent care reimbursement programs, there is a statutory maximum based upon the individual’s tax year. This test appears to require the reimbursement to be “counted” in the year in which the reimbursement is made, regardless of the account from which reimbursement is made.

It is not uncommon for testing to be run several times during the plan year to flag potential problems. (Unlike qualified plans, like 401(k) plans, there is no correction period after the plan year ends. A plan is either discriminatory or not discriminatory based upon the last day of the plan year.) With up to 2½ months to continue incurring expenses, the ability to flag and correct potential nondiscrimination issues will be greatly compromised.

COBRA
Under COBRA’s “shorty rules,” applicable to many health FSAs, the maximum period of continuation coverage is through the end of the plan year in which the qualifying event occurs. Does this mean a person entitled to COBRA through plan year end now gets the grace period to incur expenses? Based upon the principle a person on COBRA must be treated the same as a person who has not experienced a qualifying event, the answer appears to be “yes.” No further contributions would be made for the grace period; which also means the individual does not pay anything for the continued access during the grace period.

Documentation Issues
Once having decided to adopt the amendment, as well as the details of the amendment, including whether the vendor can administer the plan that way, the documentation must be reviewed and adjusted. This includes the following steps:

• Amend the plan document;
• Amend the summary plan description;
• Amend administrative material (e.g., claim forms) and consider developing a reminder notice regarding the grace period; and
• Review/revise the administrative services agreement.

We are available to assist with amending your documentation to ensure it accomplishes your objectives with respect to the application of this new rule.

Copyright : Hitesman & Wold, P.A.