CLIENT ALERT: New Section 125 Proposed Regulations Offer Employers Many New Options In Flex Administration

August 29, 2007

On Aug. 6, 2007, the IRS issued significant new proposed regulations under Section 125 of the Internal Revenue Code.  These regulations update and consolidate old IRS regulations and contain several new options and provisions. 
The new rules offer positive changes for both employers and employees and provide more clarity as to application of many of the rules. 

The regulations are generally effective for plan years beginning on or after Jan. 1, 2009, but employers may adopt the new rules now.  Changes include the following:
  • A Section 125 plan can allow participants to pay COBRA premiums on a pre-tax basis.  For example, if an employee goes from full-time to part-time and becomes ineligible for health coverage, the employee could pay the COBRA premiums pre-tax as a part-timer, or if the employee terminates employment and receives severance pay, the employee could be allowed to pay COBRA premiums from the severance pay.
  • The regulations allow employees to pay premiums for individual accident and health insurance policies on a pre-tax basis or be reimbursed for the premiums on a pre-tax basis. 
  • The regulations allow participants to make initial elections and election changes on an electronic basis consistent with IRS rules for qualified retirement plans.  Under these rules there must be a method to authenticate the employee’s identity when making the election and the employee must have an opportunity to verify and confirm his or her election.
  • If an employer wants to allow new hires to immediately participate in the employer’s benefit program, an historic problem under Section 125 has been the general prohibition on paying for retroactive periods of coverage on a pre-tax basis.  In other words, if a new hire could not immediately make his or her elections, it created an issue under Section 125.  The new regulations change this result and allow new employees who make their elections within 30 days of hire to have their elections take retroactive effect.  However, the pay reduction contributions for the elected coverage must be deducted on a prospective basis.
  • Expenses generally cannot be reimbursed from a flexible spending account until the expenses are incurred.  There is a new exception under this general rule for orthodontia expenses.  If a participant is required to pay an amount in advance for orthodontia treatment, the plan can reimburse the expense immediately even if some of the orthodontia treatment is provided in a subsequent plan year.
  • It was unclear whether an employee who terminated participation with an unused account balance in his or her dependent care FSA could spend down the unused amount following termination.  The new rules clarify that this spend down approach is permissible.
  • Employees can be required to contribute toward the reasonable administrative costs of the plan via pay reduction contributions.
  • The regulations clarify that from the IRS’s perspective, employers can keep any forfeitures from flexible spending accounts under the use-it-or-lose-it rule (now known as the use-or-lose rule).  Alternatively, the employer can apply the forfeitures to defray administrative expenses of the plan or the employer can share the forfeitures with participants on a reasonable and uniform basis.  The regulations include examples of permissible methods of doing this.
  • The regulations provide more clarity on how to apply the nondiscrimination rules under Section 125 plans.  Under the new guidance, employers will need to make sure that not only offered benefits/employer contributions not discriminate in favor of the highly compensated, it appears that they may also need to make sure that utilization of the benefits/contributions does not impermissibly favor the highly compensated.