Pension Group Questions Treasury's Position on 'Use It or Lose It' Rules for FSAs

Sam Gilbert of the Pension Forum has urged Treasury to consider his analysis that Treasury has the administrative authority to repeal or modify the "use it or lose it" aspect of flexible spending accounts, asserting that the rule has no basis in section 125 and that it was created -- and accordingly may be revoked -- by Treasury. Below is the letter sent by Sam.

                                                       May 31, 2006

The Honorable John W. Snow
Department of Treasury
1500 Pennsylvania Ave.
Washington , D.C. 20220

Re: IRC Section 125 -- The "Use it or Lose it" and "Uniform Coverage" Rules

Dear Secretary Snow:

I am writing this letter pursuant to your invitation to submit, in writing, the question I asked you regarding the "Use it or Lose it Rule" and its companion "Uniform Coverage" rule in cafeteria plans (section 125) as you addressed the U.S. Chamber of Commerce Access 2006--The Small Business Summit, Friday May 12^th.

As you may recall, I stated that nowhere in Section 125 of the Internal Revenue Code was there any reference to either the "Use it or Lose it Rule" or to the "Uniform Coverage" rule. Rather, both of these were the result of proposed Treasury regulations (still not finalized after more than 22 years). At the prompting of Tom Donohue, President and CEO of the U.S. Chamber of Commerce, you then invited me to write to you and explain why I feel the Treasury has the administrative authority to repeal or modify those rules so that you could better respond.

Please consider this letter as a request to explain Treasury's position on whether or not it has the current administrative authority to revoke or modify both rules without violating any provision of the existing statute. More specifically, do you consider the Treasury as having the current administrative authority to promulgate regulations that will allow taxpayers to rollover deferred compensation under Section 125 of the IRC so they don't lose their money in the year when they have remaining funds in flexible spending accounts? If your position is that the Treasury does not have the current authority, then how are you interpreting the statute and legislative history of Section 125 different from my understanding as outlined in my letter? If it is determined that Treasury has administrative authority to repeal or modify regulations to address this concern, then are you considering an effort to do so?

Background

Section 125 of the IRC was added as part of the Revenue Act of 1978. In 1984, Treasury issued its first set of proposed regulations under the Section (Treas. Reg. § 1.125-1 Q/A-7) which for the first time interpreted Section 125(d)(2)'s prohibition of deferred compensation within a cafeteria plan or one of its components -- with limited exceptions. Thus, the birth of the "Use it or Lose it" rule. In 1989, Treasury again published proposed regulations (never finalized) expanding upon an employer's risk of forfeiture by introducing the "Uniform Coverage" rule (Treas. Reg. § 1.125-2 Q/A-7(b)(2)), seeking to require plan sponsors to also have a so-called "insurance risk."

Use it or Lose it Analysis

While the plain language of Section 125(d)(2) would seem to preclude any kind of rollover provision from a cafeteria plan, or more specifically certain flexible spending account components from one plan year to the next, Section 125(d)(2)(B) provides an exception for cash and deferred arrangements. Thus, under the statute a participant should be allowed to defer any remaining funds at plan year-end in a flexible spending account (FSA) directly to a 401(k). While we understand that the proposed regulations require that all elections under a cafeteria plan be made in advance (Treas. Reg. § 1.125-1 Q/A-8), nothing should preclude a participant from electing prior to the beginning of the plan year, to either forfeit his or her FSA account balance at the end of the plan year, or to defer 100% of the remaining balance to a qualified 401(k) plan. If not for the proposed regulations (which Treasury has in its authority to revoke) this arrangement would fall well within the statute.

Uniform Coverage Rule Analysis

The "Uniform Coverage" rule is purely the creation of Treasury in their proposed regulations and has no basis in any part of the Tax Code. In 1989, Treasury issued its second set of proposed regulations and introduced the "Uniform Coverage" rule (Treas. Reg. § 1.125-2 Q/A-7(b)(2)). This rule posits that amounts contributed to healthcare FSAs are in fact insurance premiums, and as such any eligible claims incurred during the plan year should be reimbursed in full (up to the participant's annual election) regardless of the participant's account balance at the time the claim is incurred. However, this "insurance" argument fails immediately upon closer inspection. First, there is no insurance model of any kind anywhere in the world where the maximum amount that an "insured" can collect is equal to the "premium" they will pay towards that coverage. Second, under the current proposed regulations regarding the "Use It Or Lose It" rule, if the "insured" does not incur claims up to their premium (contribution) amount, those funds are forfeited in whole. Lastly, and perhaps most importantly, this Rule has no basis in Section 125, nor any other Section of the Tax Code. It was created wholly by Treasury and can be revoked by Treasury as well.

Senator Grassley

On August 23 2004, Senator Grassley, Chairman Senate Finance Committee wrote to you (copy of the letter attached) regarding the "Use It Or Lose It" rule. The Senator is convinced that the rule was created administratively, and not by the Congress. They believe there is no legislative foundation for the rule.

Summary

Mr. Secretary, we urge you to reconsider Treasury's ability to revoke these two rules and allow both employers and their employees to offer these plans without artificial barriers to their use. In fact, by enabling our proposal (particularly under the "Use it or Lose it" section above), Treasury would have a revenue gain since contributions to a 401(k) plan are taxable for Social Security and Medicare purposes.

Thank you very much for your consideration.

Respectfully,

Sam Gilbert
The Pension Forum

Enclosure

Cc: Tom Donohue
President and CEO U.S. Chamber of Commerce

Grassley Urges Rewrite of Rule Costing Employees Health Savings

WASHINGTON -- Sen. Chuck Grassley, chairman of the Committee on Finance, today urged the Treasury Department to change a decades-old policy penalizing employees who use tax-favored flexible spending accounts for health care.

"These flexible spending accounts are a good way to help employees meet their health care needs," Grassley said. "Unfortunately, employees have to use the money in their accounts by the end of the year, and they lose that money if they don't. That doesn't make any sense. And it's a deterrent to using flexible spending accounts. I hope the Treasury Department will fix this problem so more Americans will feel comfortable setting up these useful accounts."

Grassley wrote a letter to Treasury Secretary John Snow, saying the Treasury Department should use its administrative authority to rewrite the "use it or lose it" rule so employees don't lose all of the money in their health flexible spending accounts at the year's end. The text of his letter follows.

August 23, 2004

The Honorable John W. Snow
Department of Treasury 1500
Pennsylvania Ave. Washington ,
D.C. 20220

Dear Secretary Snow:

I am writing with regard to the so-called "use it or lose it" rule that applies to health flexible spending accounts (FSAs). As you know, section 125 of the Internal Revenue Code permits employees to contribute at the beginning of the year to an FSA in lieu of other forms of compensation. Then, as out-of-pocket (i.e., not covered by insurance) health expenses are incurred, the employee may pay for them out of the FSA with pre-tax funds. Under proposed section 125 regulations, the employee forfeits unused FSA balances at the end of the year to the employer (the "use it or lose it" rule).

The Administration advanced proposals to modify the "use it or lose it" rule in the Treasury Department's FY2002, FY2003, and FY2004 budget proposals. I believe that there are strong policy justifications for taking such action. First and foremost, I am aware of no other area of benefits law in which we allow -- let alone mandate -- that employee dollars set aside for benefit expenses revert back to the employer. The current rule unjustly enriches employers at the expense of hard-working employees who participate in FSAs.

In addition, the "use it or lose it" rule causes inefficient allocation of health care dollars by providing an incentive for employees to incur unnecessary health care expenses at the end of the year to use up the account. Of course, the "use it or lose it" rule also has the effect of dramatically reducing employee participation in FSAs because employees do not want to risk forfeiting or wasting their hard-earned money.

I know that a variety of legislative proposals have been advanced to modify or eliminate the "use it or lose it" rule. However, I would urge the Treasury Department to examine closely its authority to modify the "use it or lose it" rule administratively. Since the "use it or lose it" rule was created administratively -- and was done so through proposed regulations that have never been finalized -- it would seem that the Treasury Department does have such authority. I have heard from numerous Iowans in my home state and from taxpayers across the country that the "use it or lose it" rule makes no sense. Modifying this rule would help millions of Americans meet their health care expenses and make the FSA rules more rational.

Thank you in advance for your consideration of this letter. I look forward to your response.

Sincerely,

Chuck Grassley
Chairman, Finance Committee