Question: When can employers rely on the informal IRS “doctrine of mistake” to correct an erroneous Section 125 cafeteria plan election mid-year?
Short Answer: Informal IRS guidance provides that employers can undo a mistaken employee cafeteria plan election and implement the intended election mid-year where there is “clear and convincing evidence” of an error. This is a very high standard that will apply only in very limited circumstances.
Note: This is the seventh in a ten-part series addressing employee health plan exception requests.
General Rule: Section 125 Cafeteria Plan Irrevocable Election
Employees’ elections to pay the employee-share of the premium for health and welfare plan coverage on a pre-tax basis or make pre-tax FSA contributions are governed by Section 125 of the Internal Revenue Code. The Section 125 cafeteria plan rules are very strict when it comes to the irrevocability of employees’ elections.
That general rule under Section 125 is that all elections (including an affirmative or default election not to participate) must be:
a) made prior to the start of the plan year, and
b) irrevocable for the plan year unless the employee experiences a Section 125 permitted election change event.
The permitted election change events are set forth in Treas. Reg. §1.125-4 (e.g., marriage, divorce, birth, adoption, change in employment status affecting eligibility). Most cafeteria plans provide a window of 30 days for an employee to make a mid-year election change upon experiencing a permitted election change event.
Reason to Avoid Exceptions: Cafeteria Plan Disqualification Risk
If an employer’s cafeteria plan were to permit employees to make any mid-year (i.e., after the start of the plan year) election changes without experiencing a permitted election change event, or after the close of the plan’s election change timing window (typically 30 days), the plan would violate the irrevocable election rule described above.
Furthermore, health FSA and dependent care FSA contributions are subject to the use-it-or-lose-it rule. This rule requires that after the end of the plan year or earlier termination of employment/participation, and following any grace period and/or run-out period provided by the plan, all remaining unreimbursed contributions not subject to COBRA or a carryover provision must be forfeited to the plan.
The Section 125 rules provide that in the event of an employer’s failure to follow these regulations or the terms of the plan, the IRS could cause the entire cafeteria plan to lose its tax-advantaged status (i.e., lose the safe harbor from constructive receipt) if discovered on audit. That could result in all elections becoming taxable for all employees.
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Rare Permitted Exception: Doctrine of Mistake
IRS officials have consistently provided informal guidance stating that an employee’s cafeteria plan election may be corrected where there is “clear and convincing evidence” of a mistaken election. This approach is commonly referred to as the IRS “doctrine of mistake”.
Although the general rule is that employees’ cafeteria plan elections are irrevocable under Section 125, correcting an erroneous election under the doctrine of mistake is not treated as an impermissible mid-year election change. Rather, the employer is undoing the erroneous election (including an affirmative or default election not to participate) from ever occurring by replacing it retroactively with the election that the employee clearly intended.
While we have only informal guidance from the IRS addressing the doctrine of mistake, the federal government has issued formal materials outlining its interpretation of the scope of the rule in an Office of Personnel Management (OPM) memo discussing cafeteria plan administration procedures for federal employees. The document confirms that OPM relies on the doctrine of mistake to correct erroneous elections where there is clear and convincing evidence of the mistake.
The “clear and convincing evidence” condition to rely on the doctrine of mistake is a very high standard.
With respect to employer errors, it is generally far easier to demonstrate that the election clearly was mistaken. Examples of employer errors include data entry/processing oversights in implementing the election, eligibility mistakes that result in incorrect plan options being made available to employees, and communication snafus in describing the plan terms.
However, where the mistake is made by the employee, the employer will in most cases not have a surefire way of knowing whether the election was genuinely a mistake. The strong presumption is always that employees have just changed their mind and are attempting to use any available reasoning as a pretext to convert the election.
The facts and circumstances at issue will therefore have to be very persuasive to show that the employee made a mistake at the time of the election because a) the clear and convincing evidence bar is so high, and b) the potential disqualification risks to the plan (and associated tax consequences for the employer and employees) are so serious.
Doctrine of Mistake Situation #1: Dependent Care FSA Enrollment with No Qualifying Dependents
One situation where it is appropriate for employers to consider utilizing the doctrine of mistake to undo an erroneous election is where the employee enrolls in the dependent care FSA despite have no qualifying dependents. In this case, it is possible for the employer to establish the requisite clear and convincing evidence that a mistake has occurred because the employee cannot possibly benefit from the election.
To take advantage of the doctrine of mistake in this scenario, the employee cannot have any qualifying dependents under the dependent care FSA rules.
A qualifying dependent for dependent care FSA purposes is generally:
- The employee’s dependent child who is under age 13 when the care is provided;
- The employee’s spouse who is not physically or mentally able to care for himself or herself and lives with the employee for more than half the year; or
- A tax dependent who is not physically or mentally able to care for himself or herself and lives with the employee for more than half the year.
Note that the third item also permits individuals to qualify if they would have been a tax dependent but for the fact that they received gross income exceeding the dependency limit ($4,400, indexed) for that year, filed a joint return, or the employee or spouse could be claimed as a dependent on someone else’s tax return.
Two Approaches to Applying Doctrine of Mistake
There are two main ways that employers will utilize the doctrine of mistake to correct an erroneous election:
1. Undo Election Entirely
The standard doctrine of mistake correction approach is to undo the mistaken election entirely. In this scenario where the employee elects the dependent care FSA despite having no qualifying dependents, the standard correction would be to stop all further dependent care FSA contributions. The employer would then refund the full amount of the employee’s year-to-date dependent care FSA contributions as taxable income subject to withholding and payroll taxes to effectively put the employee in the same position as if the election had never occurred.
2. Convert Dependent Care FSA Election to Health FSA Election
In the OPM memo discussing cafeteria plan administration procedures for federal employees, the government takes the position that the doctrine of mistake can be used to move a mistaken dependent care FSA balance to a health FSA. That option would be available for employees with no qualifying dependent care FSA dependents where the employee purports to have intended to elect the health FSA instead of the dependent care FSA. This approach is somewhat more aggressive because it essentially requires clear and convincing evidence of two mistakes (i.e., the mistaken dependent care FSA election and the intended health FSA election), but employers are often comfortable with the approach given the OPM’s accommodation of such requests for federal employees.
Other Employee Dependent Care FSA Errors Do Not Support Doctrine of Mistake
In the OPM memo discussing cafeteria plan administration procedures for federal employees, the government takes the position that other dependent care FSA errors do not rise to the required level of “clear and convincing” evidence to qualify for the doctrine of mistake. For example, the guidance does not permit application of the doctrine of mistake where an employee and spouse both utilize the dependent care FSA but exceed the $5,000 combined limit for a married couple.
Employers should therefore not attempt to rely on the doctrine of mistake for where the employee has qualifying dependents but purports to have made a mistake as to the benefit’s scope or tax treatment. For example, employees may not have understood the requirement that expenses be employment-related (i.e., necessary to permit the employee and spouse to work). They may not also have understood how the dependent care FSA rules are designed for divorced or separated parents, the limitations on nanny and family member care providers, or the restrictions where a spouse works from home or is self-employed.
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There is no basis in any guidance to support employers using the doctrine of mistake to undo a dependent care FSA election in any of these situations other than where the employee has no qualifying dependents. In other words, it should be impossible for the employee to benefit from the dependent care FSA election for the employer to consider relying on the doctrine of mistake. Only in that situation can the employer confidently take the position that there is clear and convincing evidence of the mistake to support the election reversal.
If the employee could potentially benefit from the dependent care FSA election (i.e., the employee has at least one qualifying dependent), the employer should not risk cafeteria plan disqualification to accommodate the employee’s purported mistaken election.
Doctrine of Mistake Situation #2: Ben Admin System Error Causes Incorrect Health Plan Election
Another situation where it is appropriate for employers to consider utilizing the doctrine of mistake to implement an intended election is where there is clear and convincing evidence that a technical error related to the employer’s benefits administration system caused the employee to miss the applicable enrollment deadline or make an erroneous election.
For example, this situation can occur where an employee attempts to complete the election process to enroll in health plan benefits, but the benefits administration system fails to properly finalize the election. In other words, the employee partially completes the election process without implementing the elections because the system failed to properly accept the final election submission by the deadline.
To meet the very high standard of clear and convincing evidence of the mistake election (including the default election not to participate by failure to make an election) caused by the system, there should be some forensic analysis of the enrollment system available to confirm that the employee had partially completed the election process. Ideally that analysis would show what elections the employee provisionally made and attempted to submit.
Such forensics would be evidence of the system error raised by the employee and present a strong argument for the situation meeting the clear and convincing evidence standard for a mistaken election (i.e., mistaken failure to elect). Ultimately, the employer will need to determine in these situations whether it believes the specific facts and circumstances (including the types of forensic system analyses available) is sufficient to support the argument that there is clear and convincing evidence of an employee mistake in making the election.
Insurance Carrier/Stop-Loss Provider Approval Required
It is crucial that employers considering application of the doctrine of mistake to implement a late health plan enrollment caused by a benefits administration systems error first ensure that the insurance carrier (or stop-loss provider for self-insured plans) agree to the exception.
Insurance carriers (and stop-loss providers for self-insured plans) generally will pay claims only for employees and dependents who are eligible and properly enrolled pursuant to the terms of the applicable insurance policy. Carriers will in most cases permit employees to enroll only at open enrollment, upon new hire/newly eligible status, or upon the employee experiencing a permitted election change event and making an election within the required timeframe (typically 30 days). These restrictions are crucial to (among other reasons) avoid significant adverse selection issues for the carrier.
If an insurance carrier or stop-loss provider were to discover that the employer made an exception to permit an employee or dependent to enroll in any other situation without their approval, the carrier would be within its right to deny paying (or reverse payment for) all claims for that employee/dependent. That would ultimately likely make the employer responsible for self-funding all claims incurred during the period at issue—which is the worst-case scenario of potentially unlimited liability that employers must avoid.
Documenting Doctrine of Mistake: Employee Attestation to Confirm Facts and Circumstances
We recommend that employers take the following steps to document proper application of the doctrine of mistake:
- Clearly document for the employer’s file the facts and circumstances providing the basis for the employer’s finding of clear and convincing evidence of the mistaken election;
- Require the employee to sign-off on these facts; and
- Be clear in any communications that it is only in very rare circumstances that the employer could modify an election mid-year (including an affirmative or default election not to participate) without the employee experiencing a Section 125 permitted election change event.
Sample Employee Attestation Template
I understand the general rule under Section 125 is that all cafeteria plan elections (including an election not to participate by failure to elect) must be:
- Made prior to the start of the plan year; and
- Irrevocable for the duration of the plan year unless I experience a permitted election change event set forth in Treas. Reg. §1.125-4.
The circumstances in this situation constitute a rare exception under the IRS “doctrine of mistake” approach because there is clear and convincing evidence that my cafeteria plan election was made by mistake.
The facts in this situation that provide clear and convincing evidence my election was made by mistake include:
- Example #1: I mistakenly elected the dependent care FSA despite having no qualifying dependents for whom I could use the benefit to reimburse expenses.
- Example #2: Forensic data from the benefits administration system shows there was an error in processing my health plan election.
Reminder: Doctrine of Mistake is Optional
Employers are not obligated to undo an employee’s election even where there may be clear and convincing evidence of a mistaken election. For example, employers tend to be more hesitant to undo an election the later in the plan year the mistake is discovered.
The later in the plan year the issue is raised, it is both a) less likely that there is clear and convincing evidence of a mistake and more likely that an allegation of a mistake is being used as a pretext to attempt to change an election, and b) more administratively burdensome to fix the election through taxable refunds, implementing a correct election retroactively, transferring the benefit to a different arrangement, etc.
The informal IRS doctrine of mistake is a useful tool for employers to utilize in the very rare circumstances where there is clear and convincing evidence of a mistaken cafeteria plan election. Because that evidentiary bar is so high, employers will generally be able to confidently rely on the doctrine of mistake to reverse an employee’s mistaken election only where the employee enrolled in the dependent care FSA despite having no qualifying dependents, or there was a benefits administration system issue that prevented the employee from making the intended election.
U.S. OPM Benefits Administration Letter #06-801:
1. The employee thinks that he/she needs to enroll in a DCFSA to cover eligible health care expenses for his/her dependents.
Example: Holly Lawrence enrolls in a Health Care FSA with an annual election of $250 and a Dependent Care FSA with an annual election of $500. By February, she has been reimbursed her full annual HCFSA election. Holly continues to submit claims for otherwise eligible health care expenses, which are denied since her annual election amount has already been reimbursed. When Holly contacts SHPS to question the claims denials, she is surprised to learn that the DCFSA does not reimburse for health care expenses for her dependents.
4. SHPS increases the participant’s annual election for the correct account by the amount elected for the erroneous account.
Prop. Treas. Reg. §1.125-1(c)(7):
(7) Operational failure.
(i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees' elections between taxable and nontaxable benefits result in gross income to the employees.
(ii) Failure to operate according to written cafeteria plan or section 125. Examples of failures resulting in section 125 not applying to a plan include the following—
(A) Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;
(B) Offering benefits other than permitted taxable benefits and qualified benefits;
(C) Operating to defer compensation (except as permitted in paragraph (o) of this section);
(D) Failing to comply with the uniform coverage rule in paragraph (d) in §1.125-5;
(E) Failing to comply with the use-or-lose rule in paragraph (c) in §1.125-5;
(F) Allowing employees to revoke elections or make new elections, except as provided in §1.125-4 and paragraph (a) in §1.125-2;
(G) Failing to comply with the substantiation requirements of § 1.125-6;
(H) Paying or reimbursing expenses in an FSA other than expenses expressly permitted in paragraph (h) in §1.125-5;
(I) Allocating experience gains other than as expressly permitted in paragraph (o) in §1.125-5;
(J) Failing to comply with the grace period rules in paragraph (e) of this section; or
(K) Failing to comply with the qualified HSA distribution rules in paragraph (n) in §1.125-5.
The information provided is of a general nature and an educational resource. It is not intended to provide advice or address the situation of any particular individual or entity. Any recipient shall be responsible for the use to which it puts this document. Newfront shall have no liability for the information provided. While care has been taken to produce this document, Newfront does not warrant, represent or guarantee the completeness, accuracy, adequacy, or fitness with respect to the information contained in this document. The information provided does not reflect new circumstances, or additional regulatory and legal changes. The issues addressed may have legal, financial, and health implications, and we recommend you speak to your legal, financial, and health advisors before acting on any of the information provided.