The Internal Revenue Service (IRS) has provided guidance regarding the new salary reduction contribution limits to health flexible spending arrangements (health FSAs) under Internal Revenue Code section 125 cafeteria plans in Notice 2012-40, issued May 30, 2012.

Currently, there are no statutory limits on employee salary reduction contributions to health FSAs, but plan sponsors typically impose limits on the amount of salary reduction contributions that employees may elect to make to health FSAs. However, this will change when Code section 125(i) becomes effective. Code section 125(i) (added by the 2010 health care reform law) imposes a $2,500 annual limit on health FSA salary reduction contributions. The Notice clarifies that this new statutory limit is effective for plan years beginning after 2012.

In addition, Notice 2012-40 further clarifies that the limitation only applies to salary reduction contributions under health FSAs and does not apply to certain employer non-elective contributions, i.e., flex credits, or to any types of contributions or amounts available for reimbursement under other kinds of FSAs, health savings accounts, or health reimbursement arrangements or to salary reduction contributions to cafeteria pans that are used to pay an employee’s share of health coverage premiums. Moreover, run-out amounts available during the grace-period following a plan year will not count against the $2,500 limit for the subsequent year.

Cafeteria plan sponsors have until December 31, 2014, to adopt any amendments necessary to conform their cafeteria plans to the requirements of new Code section 125(i). The Notice advises that retroactive adoption of amendments for this purpose is permitted provided that the cafeteria plan operates in accordance with the requirements of section 125(i) for plan years beginning after December 31, 2012. Failure of a cafeteria plan to conform to the requirements of section 125(i) after December 31, 2012, will result in the value of the taxable benefits that an employee could have elected to receive during the plan year being includable in the employee’s gross income for the year, regardless of the benefits actually elected by the employee.

Significantly, the IRS is taking comments, through August 17, 2012, regarding whether the “use-or-lose” rule for health FSAs should be modified to allow for more flexibility. Any employer interested in submitting comments should act on this opportunity quickly. Jackson Lewis attorneys are available to assist in submitting comments as well as amending plan documents.