The Internal Revenue Service (“IRS”) recently relaxed the “use it or lose it” rule that applies to Section 125 cafeteria plans (“Section 125 Plan”), by allowing an additional 2½ month “grace period” following the end of a Section 125 Plan’s plan year. During the grace period, a participant may incur expenses that may be paid out of unused contributions carried over from the prior plan year. Previously, the IRS had interpreted the statutory prohibition on deferral of compensation contained in Section 125 of the Internal Revenue Code (“Code”) and related regulations to mean that all benefits received from a Section 125 Plan must be for expenses incurred during the plan year. If the participant incurred expenses during a plan year that were less than the amounts contributed to the Section 125 Plan, the unused contributions were forfeited.

On May 18, 2005, in Notice 2005–42 (“Notice”), the IRS modified its interpretation of the statutory prohibition of deferral of compensation to allow this 2½ month grace period. Citing regulations under Code section 404(a), and H.R. Conference Report 108–755 on the Code section 409A rules, which provide that if the grace period is of short duration it does not result in deferred compensation, the IRS stated that it is appropriate to change the rules under Code section 125 “to permit a grace period after the end of the plan year during which unused benefits or contributions may be used.”

Primary Provisions of the Notice
Significant aspects of the Notice are:

• The grace period is optional. An employer may, if it chooses, amend its Section 125 Plan to provide for a grace period immediately following the end of the plan year. This grace period may be as long as 2½ months but, if the employer chooses otherwise, may be shorter. Therefore, the maximum period over which expenses for qualified benefits may be incurred, and still be paid from benefits or contributions relating to a particular plan year, is 14 months and 15 days.
• A plan amendment will be required to implement the grace period. In order to implement the grace period for the current plan year, the employer must amend the Section 125 Plan document before the end of the current plan year.
• If a grace period is added, it must apply to all participants in the Section 125 Plan. If taken literally, and applied to the Section 125 Plan as a whole rather than its constituent parts, this requirement would prevent an employer from adding a grace period only for certain benefits. For instance, a Section 125 Plan could not provide a grace period only for health care spending account benefits and not for dependent care spending account benefits.
• Expenses for qualified benefits incurred during the grace period may be paid or reimbursed from benefits or contributions remaining unused at the end of the prior plan year, as if those expenses were incurred during the prior plan year. There is no dollar limitation on the amount of unused benefits or contributions which may be paid or reimbursed to the participant during the grace period, although the Notice does not prohibit a Section 125 Plan from including such a limitation.
• Unused contributions or benefits which relate to a particular qualified benefit may be used during the grace period only to reimburse expenses for that same qualified benefit, e.g. contributions or benefits relating to health care may only be used to reimburse health care expenses, and not dependent care expenses.
• During the grace period, the Section 125 Plan may not allow unused benefits or contributions to be cashed out or converted to any other benefit. Unused benefits or contributions cannot be carried forward beyond the maximum 2½ month period. Any benefits or contributions from the prior plan year which remain unused at the end of the grace period must be forfeited.
• Section 125 Plans may provide a “run-out” period after the end of the grace period (as they may provide now after the end of the plan year), during which expenses for qualified benefits incurred during the plan year and the grace period may be paid or reimbursed.

Advantages for Participants
Participants will likely have fewer forfeitures if they are allowed the extra time period for incurring expenses. There will also be less of a year-end race to incur qualified expenses. However, without adequate planning on the part of the participant (e.g. reducing contributions for the following plan year when there are substantial unused amounts carried over into the grace period) it is possible that a grace period will only postpone forfeiture to the following year, and transform the year-end race to an end-of-the-grace-period race.

A decrease in forfeitures, or simply a decrease in the fear of the “use it or lose it” rule, could result in greater rates of participation in the Section 125 Plan and, consequently, greater tax savings for employees and FICA and FUTA savings for the employer.

Administrative Complexity

• TimingMany calendar year Section 125 Plans currently have a March 31 deadline for submission of claims. The addition of a 2½ month grace period, coupled with a run out period, would move the deadline for submission of claims to a calendar year Section 125 Plan to a later date (e.g. June 30). This would result in a shorter time frame for completing the Section 125 Plan’s Form 5500.
• Reimbursement IssuesIn the Notice, the IRS gives examples indicating that qualified expenses incurred during a grace period would be paid first from the unused amounts from the prior year, and then the current year contributions. Administrators, on first impression, seem to agree that this is the simplest and most feasible procedure. In certain instances, and particularly for Section 125 Plans which use debit cards, this method of allocating grace period expenses could penalize the participant, as shown in the following example:
  • John is a participant in a calendar year Section 125 Plan, and has a $300 balance on December 31, 2005, which rolls over to the grace period at the start of 2006. On January 5, 2006, John uses his debit card to pay $90 in pharmacy copayments. Because grace period expenses are paid out of the unused balance from the prior year first, this $90 would be paid out of the unused $300 from the 2005 plan year, leaving a 2005 balance of $210. On January 7, 2006 the administrator receives a paper claim for $300, for a pair of glasses purchased by John on December 29, 2005. John receives only the remaining $210 balance from 2005 for the glasses. Because the glasses were purchased in 2005, no amounts from 2006 can be used to reimburse the remaining $90. If John’s pharmacy copayments had been paid from his 2006 contributions, rather than from his unused amounts from 2005, he could have been reimbursed for the full cost of his glasses.

  In order to avoid this problem, Administrators will need to develop a different, more complex, way of allocating claims payments.

Additional Administrative Costs for Employers
Adding a grace period to their Section 125 Plan will likely add to the employer’s administrative costs as follows:

• There will likely be additional administrative costs due to the increased complexity of administration of what are, essentially, continuously overlapping plan years.
• There should be a reduction in the rate of participant forfeitures. If the Section 125 Plan uses forfeitures to pay administrative expenses, this will reduce the amounts in the Section 125 Plan available to defray administrative expenses.
• The employer will need to provide additional communications to participants explaining the grace period.

Dependent Care Assistance Plan Limits
Reimbursement of dependent care expenses after the end of the plan year could cause a participant to exceed the Code section 129 limits on dependent care. Administrative procedures would need to be developed to avoid this. Code section 129 limits the amount that may be received during a calendar year from a dependent care assistance program (“DCAP”) to $5,000, or $2,500 for a married individual filing a separate return. Any amounts in excess of this limitation are subject to federal income taxation.

If a Section 125 dependent care plan implements the grace period, participants will have to pay careful attention to the balance in their dependent care accounts when they elect coverage for the next plan year. The participant must first calculate the amount, if any, to be carried over into the grace period, and then add this amount to his or her new election to make sure that the total amount does not exceed the Code section 129 limit. Failure on the part of the participant to do so will guarantee that the participant will be forced to either carry over at least the same amount into the next grace period, or receive benefits in excess of the Code section 129 limitation.

DCAP benefits must be reported in Box 10 of a participant’s W-2, which must be provided to employees by January 31 of each year. Under Code section 129, the DCAP benefits reported on a participant’s W-2 are not the amounts deferred by the participant for the Section 125 Plan year, but the amounts paid to the participant for dependent care services provided during the participant’s taxable year. Amounts paid to the participant for services provided during the grace period would be reported for the taxable year in which the grace period occurs. To the extent the participant receives benefits in excess of the Code section 129 limitation for any year, such benefits will be taxable and the employer must report this excess amount in Boxes 1, 3 and 5 of a participant’s W-2.

HIPAA and COBRA Considerations
It is possible that the addition of a grace period to a Section 125 Plan may have unintended consequences under the HIPAA portability regulations (such as loss of status as an excepted benefit). It is also unclear whether the addition of a grace period would require COBRA coverage to be extended through the end of the following plan year. We are hopeful that the IRS will publish additional guidance addressing these issues.

Conclusion
While falling far short of a repeal of the use it or lose it rule, the Notice does provide some welcome relief for participants. That relief, however, comes at a potentially high price for employers and third party administrators. Due to the apparent complexity of administration, and the number of unanswered questions surrounding the grace period, you should carefully consider the impact of adding a grace period to your Section 125 Plan. Before implementing such an amendment, you should consult with your third party administrator to ensure that they will be able to administer the grace period. You should also consult legal counsel to help you decide if the addition of a grace period is appropriate for your Section 125 Plan.