Q: My company moved to a new FSA administrator at the beginning of 2021. When the transition happened, several employees still had money left in their FSAs from their 2020 elections, which they should have been able to use during the 2021 grace period.*
However, rather than transfer these balances to the new administrator, the old administrator issued a check to the company which we were supposed to deposit in the employees’ FSAs.
To make a long story short, the money was not transferred to the employees’ accounts until this week (long after the grace period ran out). We did adopt the COVID relief provision extending the grace period through the end of the 2021 plan year, but even with the extra time, they only have a couple of weeks left to spend the FSA money before the extended grace period runs out.
We are trying to figure out how to make employees whole if they can’t spend the money in their accounts by the end of 2021. We are leaning toward refunding the money to the employees on a post-tax basis. Is this allowed? If not, do you have any other suggestions?
A: Your analysis of the situation seems to be spot on under general cafeteria plan principles. The only thing I would add is that because this was an operational error on the part of the employer, you have an obligation to fix it. The question now is, what is the best way to do so?
Unfortunately, there are no hard and fast rules on how to correct this type of error. Yet the IRS has provided key principles to consider.
First and foremost, any actions taken should restore the plan and affected individuals to the position they would have been in had the mistake not occurred. In addition:
- Corrections should be reasonable and appropriate and should not have a significant adverse effect on participants or violate the Internal Revenue Code or applicable regulations.
- Employers are required to correct errors even if doing so is inconvenient or burdensome.
- Employers should take steps to prevent the mistake from recurring.
- Full correction may not be needed where it is unreasonable or not feasible.
Regarding the last bullet, full correction in this situation may be impossible since employees didn’t have access to the money when they may have needed it most.
I’d say your options are to either refund the employees with post-tax income as you described or, possibly, to put the money back into their FSAs for them to use through the 2022 grace period.
There may be other options as well. Consult your employee benefits attorney or tax professional for additional guidance on the best approach to take.
*This question was received and answered in December 2021ꟷtwo weeks before the grace period to spend 2020 FSA funds ended. The grace period had been extended due to COVID-19.
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