The IRS weighs in on HCFSA Carryover and Reimbursement Mistakes
A. IRS Provides Guidance on Correcting Health Care FSA Reimbursement Mistakes. The IRS has released a Chief Counsel Advice (CCA) memorandum that provides guidance on correcting HCFSA payments for expenses that are not properly substantiated or are later determined to be ineligible for reimbursement (improper payments). Issues addressed include whether the correction procedures for improper debit card payments in the in the 2007 proposed cafeteria plan regulations may be applied to other improper health FSA payments, whether the steps in the debit card correction procedures can be applied in a different order, and how to report improper payments that have not been corrected after the correction procedures have been exhausted. Here are highlights:
- Broader Application of Debit Card Correction Procedures. The debit card correction procedures require 5 steps for improper debit card payments: (1) deactivate the card, (2) demand repayment, (3) withhold the payment from compensation (to the extent allowed by law), (4) apply a claims substitution or offset, and (5) treat the payment as any other business indebtedness (such as, take the same steps the employer would take to collect an equivalent business debt). According to the CCA, steps 2–5 of the procedures can also be used to correct other improper health FSA payments. So, while the Employer (as Plan Sponsor) is responsible for complying with the legal requirements for HCFSAs, a TPA (Third Party Administrator) can apply the correction procedures on the Employer’s behalf. Most Employers already follow a similar version of these correction procedures.
- Order of Correction Steps. Steps 2–4 of the correction procedures can be taken in any order, so long as the order is consistently applied for all participants. In contrast, step 5 may only be applied after the employer has pursued all correction methods in the other steps. The CCA cautions that treating an improper payment as uncollectible “should be the exception, rather than a routine process,” and that repeatedly including such payments in participants’ income suggests that the plan lacks proper substantiation procedures or may be cashing out unused HCFSA amounts. The CCA also states that steps 2–4 should be taken during the plan year in which the improper payment was made, and that any repayments will be available for reimbursing other expenses incurred during the plan year, or for carryover if permitted under the plan (subject to the limits of the IRS carryover rules). In cases where steps 2–4 were not applied during the year of the improper payment, the employer should proceed to step 5.
- Reporting Improper Payments. When step 5 is applied, the employer must first request payment consistent with its collection procedures for other business debts. If the payment is not recovered, the employer may forgive the indebtedness, in which case the payment should be reported as wages on Form W-2 for the year in which the indebtedness is forgiven. The reported amount is subject to withholding for income tax, FICA, and FUTA. Note: According to previous informal comments of IRS officials in the debit card context, Form W-2 should be used for this purpose even if the employee no longer works for the employer.
B. IRS Explains How to Preserve HSA Eligibility for Individuals With Health Care FSA Carryovers. The IRS has released a Chief Counsel Advice (CCA) memorandum that answers key questions about how Health Care FSA carryovers affect HSA eligibility. As background, HSA-eligible individuals must have qualifying high-deductible health plan (HDHP) coverage and no non-HDHP coverage other than permitted insurance, permitted coverage, coverage providing only certain types of preventive care, or coverage with a deductible that equals or exceeds the statutory minimum annual HDHP deductible (collectively, HSA-compatible coverage). When the IRS changed the “use-it-or-lose-it” rule for cafeteria plans to allow HCFSAs to offer carryovers of up to $500, questions arose about the impact of HCFSA carryovers on HSA eligibility, including what actions could be taken to preserve HSA eligibility for individuals with carryovers and how claims submitted during a general-purpose HCFSA’s run-out period should be administered if unused amounts from that plan could be carried over to an HSA-compatible HCFSA (e.g., a limited-purpose HCFSA). The CCA addresses all of those topics.
- Effect of General-Purpose HCFSA Carryovers. According to the CCA, general-purpose HCFSA coverage resulting solely from a carryover of unused amounts makes an individual ineligible to contribute to an HSA. The ineligibility lasts for the entire year into which the unused amounts are carried—it does not end when the amounts are exhausted.
- Options for Preserving HSA Eligibility. If the cafeteria plan so provides, an individual who participates in a general-purpose HCFSA can avoid the adverse effect of a carryover on HSA eligibility by declining (waiving) the carryover prior to the beginning of the next year, or by electing to participate in an HSA-compatible HCFSA and electing to have any unused general-purpose amounts carried over to the HSA-compatible-HCFSA. Alternatively, a cafeteria plan that offers both a general-purpose HCFSA and an HSA-compatible-HCFSA can provide that individuals who elect HDHP coverage for the next year will be automatically enrolled in the HSA-compatible-HCFSA, with any unused general-purpose amounts automatically carried over to that HSA-compatible-HCFSA.
- Administration During Run-Out Period. Unused amounts from a general-purpose HCFSA that could be carried over to an HSA-compatible-HCFSA may be used during the general-purpose HCFSA’s run-out period to reimburse expenses covered by the general-purpose HCFSA that were incurred during the previous plan year. During that period, expenses covered by the HSA-compatible-HCFSA must also be timely reimbursed, but reimbursements may be limited to the participant’s elected coverage amount for the new plan year (i.e., without counting the carryover). Reimbursement of any HSA-compatible claims in excess of the elected amount can be delayed until the end of the run-out period, when the amount of any carryover can be determined.
Notes: While CCAs do not bind the IRS, they are issued and shared with the public to promote more uniform tax administration on issues as they apply in general. This particular memo provides much needed guidance on the options available to employers who want to offer HCFSA carryover while helping employees keep/preserve their HSA eligibility for a subsequent plan year.