The IRS published Notice 2005-42 on May 18, 2005. This Notice modifies the "use it or lose it" rule in the cafeteria plan regulations that required participants to forfeit any unused contributions remaining in a participant's Flexible Spending Account ("FSA") at the end of a plan year. The Notice permits plan administrators to amend their cafeteria plans to create a 2½ month grace period after the end of a plan year, meaning, for example, that a cafeteria plan may now allow unused contributions remaining in a participant's FSA at the end of 2005 to be used to pay expenses incurred in the first 2½ months of 2006.

Under the cafeteria plan rules prior to this Notice, if a participant contributed $2,000 to his or her calendar year medical FSA or dependent care FSA during 2005 and had $500 left over on December 31st, the participant would forfeit the $500 remaining in his or her account. The participant could not use the $500 remaining in the account towards expenses incurred during the following year. This is known as the "use it or lose it" rule.

The new Notice changes this rule. Under the new Notice, a cafeteria plan may be amended to provide a participant with an additional 2½ months to use the balance of his or her FSA from the preceding plan year. Thus, if a participant contributes $2,000 to a medical FSA or dependent care FSA during 2005 and has $500 left over on December 31st, a cafeteria plan may now provide that the participant has until March 15th of 2006 to spend the $500 balance in the account. However if no claim is incurred within the 2½ month grace period, the balance will be forfeited. If a cafeteria plan is amended to include this grace period, whatever expenses the participant incurs during the 2½ month grace period will be paid first from any remaining FSA balance carried over from the previous year, and then from the current year's FSA contribution.

Under the new Notice, the 2½ month grace period does not automatically apply. Plan administrators are required to amend their cafeteria plans to provide for the grace period and the grace period must apply to all participants in the cafeteria plan. During the grace period, all of the other FSA rules will continue to apply. For example, unused contributions may not be cashed-out or converted to any other taxable or nontaxable benefit and unused contributions relating to a particular FSA may only be used to reimburse expenses incurred with respect to that benefit (e.g., a health FSA may only reimburse medical expenses and may not be used to reimburse dependent care expenses). Participants may continue to take advantage of a "run-out" period after the end of the grace period during which expenses for qualified benefits incurred during the plan year and the grace period may be submitted for payment or reimbursement.

It is not too late to adopt the grace period for this plan year. Plan administrators may adopt the grace period for the current plan year so long as they amend their cafeteria plan documents before the end of the current plan year. In such case, for a calendar year arrangement, a participant would have until March 15, 2006 to access amounts deferred during 2005.

If you would like to amend your plan to include the 2½ month grace period, or to discuss this or any other matter related to your organization's benefit plans, please contact a member of the Schiff Hardin LLP Employee Benefits and Executive Compensation Group.