Question: What options do employers have with how to use experience gains from health FSA or dependent care FSA forfeitures?

Short Answer: The Section 125 regulations provide employers with three options to allocate experience gains from health FSA forfeitures.  The dependent care FSA provides employers with an additional option to retain the forfeitures.  Regardless, employers overwhelmingly choose to use experience gains from forfeitures to cover all or a portion of the FSA’s administrative expenses.

General Rule: The FSA Use-It-Or-Lose-It Rule

The health FSA and dependent care FSA are components of an employer’s Section 125 cafeteria plan.  Section 125 (and its implementing regulations) imposes very strict requirements on the administration of cafeteria plans.

One of the most fundamental of these limitations is that all FSA elections are subject to the use-it-or-lose-it rule.  The rule requires forfeitures of any remaining unreimbursed funds not subject to a carryover provision after the end of the plan year (or earlier termination of employment) and any grace period and/or run-out period.

There is no option for employers to make exceptions to these rules or directly or indirectly refund to employees any unreimbursed FSA amounts remaining following termination of employment or at the end of the plan year, plus any related grace period and/or run-out period (subject to any carryover).  Engaging in this practice would risk disqualifying the entire Section 125 cafeteria plan if discovered by the IRS, potentially resulting in all elections becoming taxable to all employees.

For more details, see our related materials:

• Newfront Office Hours Webinar: Section 125 Cafeteria Plans

• Missing the Dependent Care FSA Run-Out Period

• Health FSA Reimbursements After Termination from Employment

• The Carryover vs. the Grace Period

Note that multiple options to avoid forfeitures are temporarily available under the CAA FSA relief provisions, including expanded carryover, grace period, election change, and spend down features.

**Experience Gains from Health FSA Forfeitures: **Permitted Uses

The Section 125 regulations generally provide the following three permitted plan uses of experience gains resulting from health FSA forfeitures:

• To reduce required salary reduction amounts for the immediately following plan year, on a reasonable and uniform basis;

• Returned to employees on a reasonable and uniform basis; or

• To defray expenses to administer the health FSA.

There is no option for employers to make exceptions to these rules.  Failure to allocate experience gains consistent with these options would risk disqualifying the entire Section 125 cafeteria plan if discovered by the IRS, potentially resulting in all elections becoming taxable to all employees.

Note that experience gains are the result of annual forfeitures reduced by the health FSA’s losses from overspent accounts by employees who terminate mid-year.  The experience gains (if any) may be significantly lower than the gross forfeiture amount if there are many mid-year terminations with overspent accounts.

• For more details, see: Overspent Health FSAs Upon Termination from Employment.

Employers should consult the terms of the Section 125 cafeteria plan to confirm whether all three approaches are available under the plan.  Employers should also keep records of experience gain amounts available and their application under one of these permitted three approaches.

Option 1: Uniformly Reducing Required Salary Reduction Amounts in Subsequent Plan Year (Uncommon)

Employers choose to apply experience gains from forfeitures to the plan’s administrative expenses in the vast majority of situations.  It is uncommon for employers to use forfeitures for any purposes other than to cover all or a portion of the health FSA’s administrative expenses.

For the rare situations where the employer chooses to utilize the option to apply health FSA experience gains (forfeitures reduced by losses from overspent mid-year terminations) to reducing employees’ required contributions for the following plan year, the experience gains are spread evenly among all participants—regardless of whether they forfeited any amount.  Therefore, the approach generally results in a small contribution reduction for each employee.  That allocation will in no way reflect each employee’s particular claims experience (i.e., forfeitures) from the prior plan year.

The option to reduce employees’ required salary reduction amounts would provide employees in the immediately following plan year with a larger health FSA account balance than the amount of their election.  Conceptually the approach is similar to a partial premium holiday applied to the health FSA.

Employers could apply the reduction on a standard per capita or proportional weighted approach.  Under the standard per capita approach, each health FSA participant would have the cost of their election reduced by the same amount.  For example, assume the experience gains would support a reduction of $50 per employee.  In that example, an employee’s election of $2,750 for the subsequent plan year would actually result in employee salary reduction contributions of only $2,700.  Likewise, an employee’s election for $1,000 would cost the employee only $950.

Under the proportional weighted approach, the employer would adjust the cost of each health FSA participant’s election relative to the election amount.  For example, an employee’s election of $2,750 for the subsequent plan year might result in a $110 reduction, meaning the employee would have salary reduction contributions of only $2,640.  The employee who elected $1,000, on the other hand, might have a reduction of only $40, meaning the employee would have a salary reduction contribution of $960.

Again, these experience gain amounts can be returned to employees only on a reasonable and uniform basis.  The amounts must be spread evenly over all employees with no adjustment based on whether or how much the employee forfeited.

Option 2: Uniformly Returning Funds to Employees (Uncommon)

Employers choose to apply experience gains from forfeitures to the plan’s administrative expenses in the vast majority of situations.  It is uncommon for employers to use forfeitures for any purposes other than to cover all or a portion of the health FSA’s administrative expenses.

For the rare situations where the employer chooses to utilize the option to return the health FSA experience gains to participants, the rules permit employers to provide cash refunds “on a reasonable and uniform basis.”  This approach does permit refunds based on the amount of any forfeitures experienced by a particular participant.  In other words, the employer cannot base the refund on the individual amount forfeited by the employee.

Rather, this permits the employer to spread the total experience gain amount (i.e., forfeitures reduced by losses from overspent mid-year terminations) as a refund to all employees who participated.  For example, if an FSA has $10,000 in experience gains and 200 employees who participated, the employer could provide a cash refund to each employee of $50 under the per capita approach.  The refund to employees would be taxable income subject to withholding and payroll taxes.

Again, these experience gain amounts can be returned to employees only on a reasonable and uniform basis.  The amounts must be spread evenly over all employees with no adjustment based on whether or how much the employee forfeited.

Option 3: Applying to Health FSA Administrative Expenses (Very Common)

Employers almost always apply experience gains from health FSA forfeitures to the cost of administering the health FSA.  Most often the funds are applied to the TPA’s service fee to administer the plan.  This is the simplest and least burdensome approach.

Keep in mind that the health FSA experience gains from forfeitures cannot be used to fund the administrative expenses for another benefit such as the health plan, dependent care FSA, wellness program, lifestyle spending account, or commuter benefits.  Employers have a fiduciary duty under ERISA to act solely in the best interest of plan participants and beneficiaries.  Applying experience gains to other benefits would likely breach that exclusive benefit rule because not all health FSA participants would be participants in those other benefits, and therefore the funds would not be used for the health FSA participants’ exclusive benefit.

• For more details, see our Newfront ERISA for Employers Guide.

Experience Gains from Dependent Care FSA Forfeitures: Permitted Uses

The same three permitted uses of experience gains from health FSA forfeitures described above also apply to dependent care FSA forfeitures.

However, employers also have one additional option with dependent care FSA forfeitures: The employer may simply retain the dependent care FSA experience gains in the employer’s general assets for any use or purpose—even those unrelated to the plan.

This option is available for dependent care FSA experience gains because the benefit is not subject to ERISA.  Therefore, the fiduciary duty of loyalty frequently referred to as ERISA’s exclusive benefit rule does not apply to the dependent care FSA.

Note that while this fourth approach is permitted under the Section 125 regulations, employers would still need to confirm that the written terms of the cafeteria plan document do not prohibit employer retention of experience gains from forfeitures.

Commuter Benefit Forfeitures: Different Rules Apply Under §132

Commuter mass transit/vanpool and parking benefits are not cafeteria plan benefits.  Rather, they are governed by Section 132(f).

The §132 rules are clear that only current employees can participate in the commuter account.  Furthermore, the prohibition on refunds or cash outs of unused commuter account balances extends to situations where the employee ceases to participate, such as participation of employment.  Any unused commuter balance upon termination must be forfeited to the employer after any applicable run-out period.

The good news is employers may retain commuter account forfeitures, allocate them evenly to the accounts of other commuter participants, use the amounts for plan administrative expenses, or use them any other purpose.  Unlike the Section 125 cafeteria plan rules applicable to experience gains caused by FSA forfeitures, there are no Section 132 rules governing employer use of forfeitures.

For more details, see:

• Commuter Accounts When Expenses Dry Up

• Commuter Benefits Upon Termination of Employment

Regulations

Prop. Treas. Reg. §1.125-5(o):

(o) FSA experience gains or forfeitures.

(1) Experience gains in general. An FSA experience gain (sometimes referred to as forfeitures in the use-or-lose rule in paragraph (c) in this section) with respect to a plan year (plus any grace period following the end of a plan year described in paragraph (e) in §1.125-1), equals the amount of the employer contributions, including salary reduction contributions, and after-tax employee contributions to the FSA minus the FSA’s total claims reimbursements for the year. Experience gains (or forfeitures) may be—

(i) Retained by the employer maintaining the cafeteria plan; or

(ii) If not retained by the employer, may be used only in one or more of the following ways—

(A) To reduce required salary reduction amounts for the immediately following plan year, on a reasonable and uniform basis, as described in paragraph (o)(2) of this section;

(B) Returned to the employees on a reasonable and uniform basis, as described in paragraph (o)(2) of this section; or

(C) To defray expenses to administer the cafeteria plan.

(2) Allocating experience gains among employees on reasonable and uniform basis. If not retained by the employer or used to defray expenses of administering the plan, the experience gains must be allocated among employees on a reasonable and uniform basis. It is permissible to allocate these amounts based on the different coverage levels of employees under the FSA. Experience gains allocated in compliance with this paragraph (o) are not a deferral of the receipt of compensation. However, in no case may the experience gains be allocated among employees based (directly or indirectly) on their individual claims experience. Experience gains may not be used as contributions directly or indirectly to any deferred compensation benefit plan.

(3) Example. The following example illustrates the rules in this paragraph (o):

Example. Allocating experience gains.

(i) Employer L maintains a cafeteria plan for its 1,200 employees, who may elect one of several different annual coverage levels under a health FSA in $100 increments from $500 to $2,000.

(ii) For the 2009 plan year, 1,000 employees elect levels of coverage under the health FSA. For the 2009 plan year, the health FSA has an experience gain of $5,000.

(iii) The $5,000 may be allocated to all participants for the plan year on a per capita basis weighted to reflect the participants’ elected levels of coverage.

(iv) Alternatively, the $5,000 may be used to reduce the required salary reduction amount under the health FSA for all 2009 participants (for example, a $500 health FSA for the next year is priced at $480) or to reimburse claims incurred above the elective limit in 2010 as long as such reimbursements are made on a reasonable and uniform level.

Prop. Treas. Reg. §1.125-1(c)(7):

(7) Operational failure.

(i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees’ elections between taxable and nontaxable benefits result in gross income to the employees.

(ii) Failure to operate according to written cafeteria plan or section 125. Examples of failures resulting in section 125 not applying to a plan include the following—

(A) Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;

(B) Offering benefits other than permitted taxable benefits and qualified benefits;

(C) Operating to defer compensation (except as permitted in paragraph (o) of this section);

(D) Failing to comply with the uniform coverage rule in paragraph (d) in §1.125-5;

(E) Failing to comply with the use-or-lose rule in paragraph (c) in §1.125-5;

(F) Allowing employees to revoke elections or make new elections, except as provided in §1.125-4 and paragraph (a) in §1.125-2;

(G) Failing to comply with the substantiation requirements of § 1.125-6;

(H) Paying or reimbursing expenses in an FSA other than expenses expressly permitted in paragraph (h) in §1.125-5;

(I) Allocating experience gains other than as expressly permitted in paragraph (o) in §1.125-5;

(J) Failing to comply with the grace period rules in paragraph (e) of this section; or

(K) Failing to comply with the qualified HSA distribution rules in paragraph (n) in §1.125-5.

ERISA §404(a)(1)(A):

(a) Prudent man standard of care._(1) _Subject to sections 403(c) and (d), 4042, and 4044, a fiduciary shall discharge his duties with respect to a plan solely in the interest of the participants and beneficiaries and—

(A) for the exclusive purpose of:

(i) providing benefits to participants and their beneficiaries; and

(ii) defraying reasonable expenses of administering the plan.