Employees make mistakes while enrolling. Mistaken enrollment into the Dependent Care FSA seems to be a common problem.
Question: An employee enrolled in the dependent care FSA even though he has no children. It was clearly a mistake. Can we do anything?
Compliance Team Answer:
The short answer is it that although it is generally extremely difficult to change an employee’s Section 125 election based on a mistake, this is a rare scenario where we feel comfortable permitting the election change because the employee had no dependents eligible for the DCAP.
As described in more detail below, an employee generally can make a mid-year election change only upon experiencing a Section 125 permitted election change event absent very unusual circumstances. Those very unusual circumstances are based on the informal IRS “doctrine of mistake.” Based on guidance from the Section 125 cafeteria for federal employees, this is a scenario where it is reasonable to apply doctrine of mistake for an employee who elects to make contributions to the DCAP despite having no eligible dependents.
General Rule: Irrevocable Election
That general rule under Section 125 is that all elections (including an election not to participate) must be 1) made prior to the start of the plan year (i.e., prospective), and 2) irrevocable for the plan year unless the employee experiences a 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). That section does not refer to any doctrine of mistake as a basis for changing an election.
Rare Exception: Doctrine of Mistake
However, IRS officials have consistently provided informal guidance stating that an employee’s election can be changed where there is “clear and convincing evidence” that a mistake has been made. The argument is that you’re not changing an election mid-year, you’re undoing the election from ever occurring.
This clear and convincing requirement is a very high standard. If the mistake is made by the employer (e.g., data entry, data processing, or other administrative errors), it is much easier to show that there clearly was a mistake. Where the mistake is made by the employee, the employer will often not have a surefire way of knowing whether it was genuinely a mistake, or the employee just changed his mind. The facts and circumstances at issue will have to be very persuasive because the clear and convincing evidence bar is very high.
If the cafeteria plan were to permit employees to make a mid-year election change based on this type scenario without clear and convincing evidence of a mistake, there is a risk that an IRS audit could result in the entire cafeteria plan being disqualified. This would make all elections taxable for all employees. (See cites below)
Facts in This Situation Support the Doctrine of Mistake
To show clear and convincing evidence that the doctrine of mistake should apply here, our opinion is that the employee would need to have no dependents who can benefit from the DCAP. Where an employee has no qualifying dependents, it is possible to establish the requisite clear and convincing evidence that a mistake has occurred. This approach is supported by how the federal government administers its own cafeteria plan for federal employees (cite below).
If the employee could benefit from the DCAP election (i.e., she has qualifying dependent(s)), this scenario would be exactly the type of mid-year election change that Section 125 rules are designed to prevent. IRS guidance is clear that a mistake as to the benefit’s scope or tax treatment does not justify an election change.
It appears from the scenario you described that the employee had no dependents whose care expenses qualify for reimbursement under the DCAP. Assuming the employee has no children, all of the employee’s children (if any) are age 13 or older with no disabilities, or the employee does not have a disabled spouse or other dependent whose expenses may qualify for DCAP reimbursement, it would be impossible for the employee to benefit from the mistaken DCAP election.
Summary: Suggested Approach
Do not permit the election change unless there is clear and convincing evidence of the mistake. Our opinion is that this standard can be satisfied only if the employee has no dependents who could benefit from the DCAP election.
If the company permits the election change in this case, we suggest that the company:
- Clearly document the reason for the election change (i.e., the facts supporting clear and convincing evidence of the mistake—in this case no qualifying dependents);
- Require the employee to sign off on these facts; and
- Be clear in any communications that it is only in very rare circumstances like these that an employer could revoke an existing election without the employee experiencing a permitted election change event.
If the company takes this approach, the mistaken election would be corrected by refunding the full amount of the employee’s DCAP contributions as taxable income subject to withholding and payroll taxes.
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.
Example: When enrolling during Open Season, Ann Green inadvertently enters a dollar amount election for a DCFSA. Ann has no children and no other eligible dependents, so she cannot benefit from her mistaken election.
Under FSAFEDS policy, and in accordance with Internal Revenue Service guidelines, these “mistaken elections” can be corrected via Account Funds Transfer (AFT), as long as there is clear and convincing evidence that the election is indeed mistaken.
(b) Definitions of qualifying individual and employment-related expenses.
For purposes of this section—
(1) Qualifying individual.
The term “qualifying individual” means—
(A) a dependent of the taxpayer (as defined in section 152(a)(1)) who has not attained age 13,
(B) a dependent of the taxpayer (as defined in section 152 , determined without regard to subsections (b)(1), (b)(2) , and (d)(1)(B) ) who is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than one-half of such taxable year, or
(C) the spouse of the taxpayer, if the spouse is physically or mentally incapable of caring for himself or herself and who has the same principal place of abode as the taxpayer for more than one-half of such taxable year.
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