Question: How should employers handle FSA contributions, the employee-share of the premium for group health plan and group term life imputed income on a final paycheck?
Compliance Team Response:
Part I: FSA Contributions—Does the employer have to take the employee’s elected FSA salary reduction contribution on the final paycheck?
General Approach to FSA Contributions on Final Paycheck
It’s a good question with no clear answer in the Section 125 regulations or clear industry consensus on how to handle.
Our opinion is that the employee does not experience the permitted election change event until he or she terminates employment, and therefore technically the election should continue all the way through the last paycheck.
However, there are two reasons why we are not too concerned if the employer doesn’t always follow this practice:
- That can seem unfair to employees who terminate early in a pay period and therefore may have a large percentage of their paycheck allocated to the FSA contribution; and
- You could avoid that issue by prorating the contribution amount based on the number of days in the pay period before the employee terminates, but that’s administratively complex and probably not reasonable to always expect from employers.
Therefore, we generally advise that it’s fine for the employer to handle FSA contributions on the final paycheck however they believe is most appropriate. The most common approach seems to be to include the full FSA contribution on the last paycheck, but we generally are not concerned if you want to take a different approach. The IRS has never been clear on this point, and therefore it is unlikely they would take issue with any of these approaches.
Applying to Company’s Current Practice
The FSA permits reimbursement for expenses incurred at least through the employee’s termination date, so it is appropriate to take an FSA contribution on the final paycheck.
While technically the proper approach would probably be to prorate the contribution based on the portion of the period in which he was employed (e.g., 7/15ths), we rarely see employers implement prorating in payroll systems. Our experience is most employers take the full contribution amount on the final paycheck.
If that is the case, we would recommend either:
- Adopting the less common policy of never including FSA contributions on final paychecks (greater cost to the company); or
- Take the more common approach of including the full FSA contribution in the final paycheck.
Part II: Employee-Share of the Premium—Can the employer take a full-month contribution on the final paycheck if the employee terminates in the first half of the month (but coverage runs through the end of the month)?
Our recommendation is that the company discontinue its practice of doubling-up the employee-share of the premium where an employee terminates employment in the first half of the month (and therefore receives only one paycheck, but receives coverage through the end of the month).
Section 125 Uniform Interval Rule
The Section 125 cafeteria plan regulations that govern employee pre-tax contributions for health coverage require that the interval for employee salary reductions be uniform for all participants. This means that you couldn’t have one employee paying contributions at a different interval than another (e.g., one pays each paycheck while one pays each month).
Doubling-up on employee contributions for a mid-month termination likely violates that requirement. Although it’s not explicit in the regulations that salary contributions be taken ratably, it would defeat the purpose of the uniform interval requirement to provide that employees may be paying different amounts at the set uniform interval. Therefore, most view doubling-up on contributions as not permitted under Section 125.
For example, this means that if an employee elects a plan option with an employee-share of the premium that is $6,000 per year, and the company has 24 pay periods, the contribution per semi-monthly pay period is $250. It cannot be $300 one pay period, $200 the next, etc. Of course, these can change mid-year if the contribution structure changes mid-year, but absent that unusual situation the contributions will be taken ratably throughout the year.
Our recommendation is therefore that the company should not deduct the full month’s employee-share of the premium where the employee terminates in the first half of the month. The company should instead be limited to taking the standard per-paycheck employee-share of the premium contribution.
In many cases, this comes out as a wash to the employer because the carrier will not require premiums for coverage until the first full month of employment (frequently referred to as the “wash rule”). So even though the employee will not be paying for the full month of coverage when terminating in the first half of the month, the employee contributions for the first partial month of coverage as of date of hire could cause this to come out as a “wash” in the end.
Part III: Group Term Life Imputed Income—How is GTL excess coverage income imputed for a partial month of coverage where an employee terminates mid-month?
The general rule that any employer-provided GTL coverage in excess of $50,000 will result in imputed income to the employee under §79 based on the IRS Table I rates, with coverage determined on a monthly basis.
Prorated Imputed Income for Partial Month Coverage
The technically correct approach for a mid-month termination is to prorate the §79 GTL imputed income amount if an employee’s GTL coverage terminates mid-month based on the number of days of coverage in that month.
However, our experience is it is common for prorated imputed income not to be implemented on the payroll side. Our sense is that it’s more common for the payroll system to take the full month’s imputed income amount—even where coverage terminated mid-month.
There is no compliance issue with either approach. The IRS is concerned with receiving at least the prorated amount of the imputed income. If the payroll system is not setup to take a prorated imputed income amount, there is no issue with taking imputed income for the full month. This simply results in a tiny amount of additional revenue to the IRS. There would be a potential issue if the payroll system took no imputed income for that partial month coverage (or a prorated amount less than the period of coverage for the partial month), but we have not seen that approach in practice.
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.
Prop. Treas. Reg. §1.125-2(a):
(a) Rules relating to making and revoking elections.
(1) Elections in general. A plan is not a cafeteria plan unless the plan provides in writing that employees are permitted to make elections among the permitted taxable benefits and qualified benefits offered through the plan for the plan year (and grace period, if applicable). All elections must be irrevocable by the date described in paragraph (a)(2) of this section except as provided in paragraph (a)(4) of this section. An election is not irrevocable if, after the earlier of the dates specified in paragraph (a)(2) of this section, employees have the right to revoke their elections of qualified benefits and instead receive the taxable benefits for such period, without regard to whether the employees actually revoke their elections.
Prop. Treas. Reg. §1.125-5(g)(2):
(2) Interval for employees’ salary reduction contributions. The cafeteria plan is permitted to specify any interval for employees’ salary reduction contributions. The interval specified in the plan must be uniform for all participants.
Treas. Reg. §1.79-3(c):
(c) Period of coverage. For purposes of this section, the phrase “period of coverage” means any one calendar month period, or part thereof, during the employee’s taxable year during which the employee is provided group-term life insurance on his life to which the rule of inclusion set forth in section 79(a) applies. The phrase “part thereof” as used in the preceding sentence means any continuous period which is less than the one calendar month period referred to in the preceding sentence for which premiums are charged by the insurer.
Treas. Reg. §1.79-3(d)(2):
(2) For the cost of group-term life insurance provided after June 30, 1999, the following table sets forth the cost of $1,000 of group-term life insurance provided for one month, computed on the basis of 5-year age brackets. See 26 CFR §1.79-3(d)(2) in effect prior to July 1, 1999, and contained in the 26 CFR part 1 edition revised as of April 1, 1999, for a table setting forth the cost of group-term life insurance provided before July 1, 1999. For purposes of Table I, the age of the employee is the employee’s attained age on the last day of the employee’s taxable year.
Table I.—Uniform Premiums for $1,000 of Group-Term Life Insurance Protection
IRS Publication 15-B: Employer’s Tax Guide to Fringe Benefits
Figure the monthly cost of the insurance to include in the employee’s wages by multiplying the number of thousands of dollars of all insurance coverage over $50,000 (figured to the nearest $100) by the cost shown in Table 2-2. For all coverage provided within the calendar year, use the employee’s age on the last day of the employee’s tax year. You must prorate the cost from the table if less than a full month of coverage is involved.
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