Tom Hughes

Under the Rules relating to Section 125 Plans, participants make an election prior to the start of a Plan Year of the dollar amount of qualifying benefits that they will put into and be reimbursed for out of the 125 Plan.

According to the traditional rules for a 125 Plan, a participant forfeited any balance left in that account if eligible expenses were not incurred by the last day of the Plan Year. The dollar amounts that were forfeited went back into the Plan as a general asset. This rule was known as the “use it or lose it” rule.

Pursuant to an unexpected IRS Notice, the IRS has declared that the “use or lose it” rule was too harsh. As a result, their new ruling replaces it with the “spend it within 2 ½ months later” grace rule.

According to the IRS Notice 2005-42, the use it or lose it rule was required under Section 125 of the Internal Revenue Code so that the Cafeteria Plan did not permit deferred compensation. However, the IRS said that the use it or lose it rule created practical problems. Since other areas of the Internal Revenue Code permit mistakes to be remedied for short periods following the year in which the services that are being compensated were performed, the IRS concluded a similar rule should be applied to Section 125 Plans.

As a result, the IRS Ruling states that a Cafeteria Plan Document may be amended to provide for a grace period immediately following the end of each Plan Year. The grace period must apply to all participants in the Cafeteria Plan. 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 immediately preceding Plan year. The grace period must not extend beyond the 15th day of the third month (2 ½ months) after the end of the immediately preceding Plan Year to which it relates.

If a Cafeteria Plan Document is amended to include a grace period, a participant who has unused contributions relating to a particular qualified benefit from the immediately preceding Plan Year and who incurs expenses for that same qualified benefit during the grace period may be paid or reimbursed for those expenses from the unused benefit contributions as if the expenses had been incurred in the immediately preceding Plan year. According to the IRS, the effect of the grace period is that a participant may have as long as 14 months and 15 days to spend the elected benefits before they are lost under the use it or lose it rule.

Not surprisingly, the Plan may still not permit any unused benefits to be cashed out or converted into any other taxable or nontaxable benefit during the grace period. In addition, the unused benefits for any particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that particular qualified benefit in the 2 ½ months following the end of the Plan Year.

For example, unused amounts to pay or reimburse medical expenses in a health flexible spending account may not be used to pay or reimburse dependent care expenses incurred during the grace period. As with current practice, Plans can still continue to provide a claims run out period after the end of the grace period, during which the expenses for qualified benefits incurred during the Cafeteria Plan Year and the grace period may be submitted to be paid.

In order to take advantage of this change, your Cafeteria Plan will need to be amended to add the 2 ½ month grace period during the following Plan Year to soak up benefits that the Plan participants would otherwise lose. In the event that the participant does not incur sufficient expenses in the grace period to cover all of the elected expenses, the use it or lose it rule still applies.

Although the ruling does not specifically say so, it appears that this ruling will only be effective for the current Plan Year moving forward. Since most of the Cafeteria Plans with which we work are calendar year Plans, and the elections for the year 2005 have already been made, you should consider amending your Cafeteria Plan to add the 2 ½ month catch-up period effective January 1, 2006 through March 15, 2006.

If you have any questions, please do not hesitate to contact Tom Hughes of our Minneapolis Office.

Founded in Saint Paul in 1943, Felhaber, Larson, Fenlon and Vogt, P.A. has offices in Minneapolis and Saint Paul. With over 55 attorneys, the firm serves clients in the areas of corporate and commercial law, employee benefits, employment law, estate planning, health care, intellectual property, labor law representing management, litigation, real estate, transportation law, and workers' compensation.