IRS Final Family and Medical Leave Act Regulations
and Cafeteria Plans

On October 17, 2001, the Internal Revenue Service (IRS) issued the final Family and Medical Leave Act (FMLA) regulations. These regulations address the options which an employer must offer its employees, who are absent from work as a result of a FMLA leave, regarding the employee's cafeteria plan elections. The final regulations (Treas. Reg. 1.125-3) give the employer more options surrounding FMLA leave administration than the 1995 proposed regulations. The proposed regulations generally stated that an employee on FMLA leave must be allowed to revoke their Heath Care Spending Account (HCSA) election during the FMLA leave, or be allowed to continue the coverage with three options for payment. Furthermore, the employee could re-elect coverage if they wished upon return from FMLA leave, but could not be compelled to do so. Under the final regulations, the employer may require that an employee continue HCSA coverage during unpaid FMLA leave and must re-enroll in the HCSA upon return from FMLA leave. Although the final regulations specifically address unpaid FMLA, they do give some guidance as to how employees on paid FMLA leave and non-FMLA leaves must be treated in certain situations. The following is a summary of the final regulations which outlines the choices employers have regarding unpaid FMLA leave.

The employer may allow the employee to discontinue HCSA coverage during an unpaid FMLA leave, and the employee will not be eligible to incur or be reimbursed for any expenses during the period of non-coverage. The employer may also require the employee to re-enroll in the HCSA upon the employee's return from unpaid FMLA leave, if the employer also requires employees who return from unpaid non-FMLA leave to re-enroll in the HCSA. If the employer requires re-enrollment in the HCSA, the employee must be allowed to choose one of the following two payment options:

1. Proration: The employee may elect to reinstate a level of coverage that is reduced by the amount of contributions missed during the unpaid FMLA leave based on the original plan year contribution election amount; or
2. Reinstatement: The employee may elect to reinstate the level of coverage in effect when the leave commenced, so long as the employee pays any contribution amounts missed during the unpaid FMLA leave, plus any future required contributions.

Conversely, the employer may require the employee to continue HCSA participation during unpaid FMLA leave, as long as the employer pays the employee's share of the HCSA contribution during the employee's unpaid FMLA leave. Upon the employee's return from unpaid FMLA leave, the employer is entitled to repayment of the employee's share of HCSA contributions ("Catch-up" option) from payroll deductions. Furthermore, should the employee not return to employment, the employer is entitled to recover any contributions which the employer has paid on the employees behalf while the employee was on unpaid FMLA leave.

In cases where an employer allows the Employee to choose between the options of discontinuation or continuation of the employee HCSA during unpaid FMLA leave, the employee may elect to continue coverage, by making the applicable contributions in the following modes:

• Pre-payment made prior to the commencement of the FMLA period on a pre-tax or after-tax basis; or,
• "Pay-as-you-go" basis during the term of the leave on an after-tax basis or pre-tax basis to the extent that the contributions are made from taxable compensation; or,
• "Catch-up" option based on verbal agreement with your employer.

Should the employee select the "pay-as-you-go" option and the employee fails to make the required contributions, the employer may (1) either terminate the employee's coverage under the HCSA or (2) continue the employee's coverage by paying the premiums and invoking the employer's right to enforce the "catch-up" option.

The employer may require that if the employee elects to continue in the HCSA during unpaid FMLA leave, the employee must utilize the "catch-up" option, if and only if, it is the only option afforded to those employees on unpaid non-FMLA leave.

If the employee leave constitutes a paid FMLA leave, the employer may, at its discretion, require that the Employee continue to participate in the HCSA, as long as the Employer requires HCSA continuation of coverage during an employee's non-FMLA paid leave.

While on FMLA leave, the employee must be afforded the same rights regarding to open enrollment and status change election modifications as those employees participating in the HCSA who are not on FMLA leave.

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Definition of Key Employee Modified by EGTRRA

As part of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA), the definition of Key Employee in relation to nondiscrimination testing has been modified for plan years beginning January 1, 2002 and after as follows:

Key Employee (plan years beginning January 1, 2002 and after)

• An officer of the employer whose annual compensation is greater than $130,000 (as indexed);
• A more than 5% owner of the employer; or
• A more than 1% owner of the employer with annual compensation in excess of $150,0000

Prior to the passage of EGTRRA, the nondiscrimination testing definition for Key Employee was as shown below:

Key Employee (plan years beginning prior to January 1, 2002)

• An officer with annual compensation greater than 50% of the defined benefit plan dollar limit in effect for the year. This compensation level is $60,000 (1995 - indexed); or
• one of the ten employees having annual compensation greater than $30,000 (1995 - indexed) and owning both more than 1/2% interest and the largest interests in the employer; or
• an employee with more than 5% ownership; or
• an employee with more than 1% ownership and annual compensation greater than $150,000.

As a result of the definition modification the following changes will occur:

• Officers will not be considered to be Key Employees unless they earn $130,000 (indexed) as opposed to $70,000 (indexed) for the year 2001;
• The top ten owner-employees category has been eliminated;
• The four-year look back period is eliminated.

In most cases, the change in the definition of Key Employee as a result of the passage of EGTRRA will result in fewer employees being considered Key Employees for cafeteria nondiscrimination testing purposes.

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H.R. Bill 3105 Would Modify FSA "Use-It -Or-Lose-It" Provision

On October 11, 2001, a bill was introduced into the House of Representative that would modify the "use-it-or-lose-it" provision currently contained in Section 125 plan in regards to Heath Care Spending Accounts (HCSA). This proposed legislation would allow HCSA participants to carry over amounts of up to $2,000 of unused HCSA balances to the participants HCSA in subsequent plan years. These balance amounts would be taxed as additional wages in the tax year in which they were carried over and could be used only for qualified medical care expenses as referenced in the Section 125 regulations. However, this bill would also permit terminated employees to utilize any positive balances in their HCSA to assist them in paying for the continuation of coverage for their medical insurance coverage. Furthermore, the proposal would permit employees to accumulate funding for eventual retiree medical expenses and to pay for Medicare supplemental insurance.

The sponsor of this legislation, Representative Ed Royce, made the following statements in a letter dated October 16, 2001 to his House colleagues.

"My bill would permit employees to carryover unused funds, so the emphasis would change from 'use-it-or-lose-it' to 'save-it-and-keep-it'. Predicting annual medical expenses is difficult at best, but medical disasters do occur. Permitting employees to keep their own money in a spending account as a rainy day fund for medical emergencies makes good sense. Rather than workers losing money leftover at the end of the year, my proposal would tax those funds which carryover into the next year as additional wages. This will reduce any revenue impact, prevent employees from losing their reimbursement account and encourage saving for future medical expenses."

The proposed legislation would apply to tax years beginning after December 31, 2001. ProBusiness will monitor and keep you informed on the progress of this bill.

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IRS Releases Year 2001 Form 2441

The IRS has released the Form 2441 and the accompanying instructions for the tax year 2001. This tax form entitled "Child and Dependent Care Expenses," must be filed with the employees tax return (1040 or 1040A), when that employee elects to claim the dependant care tax credit or to notify the IRS of why the child care benefits received under a cafeteria plan (as indicated in Box 10 of the W-2) are not taxable income to the employee. The Form 2441 to be used by the employee when they file either Tax Form 1040 or 1040A and its instructions can be found on the links below.

Form 2441 and Instructions to be used with Form 1040:

http://www.fedworld.gov/pub/irs-pdf/f2441.pdf - Form
http://www.fedworld.gov/pub/irs-pdf/i2441.pdf - Instructions

Form 2441 and Instructions to be used with Form 1040A:

http://www.fedworld.gov/pub/irs-pdf/f1040as2.pdf - Form
http://www.fedworld.gov/pub/irs-pdf/i1040as2.pdf - Instructions

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FICA Wage Base Limit for 2002

The Social Security Administration announced on October 19, 2001, that the maximum amount of earnings that will be subject to the Social Security tax of 6.2% will increase to $84, 900 from the current $80,400 effective for the tax year beginning January 1, 2002. The Medicare tax of 1.45% will continue to be assessed on all earnings with no limit.

Please contact ProBusiness for further information at:
20000 North Creek Parkway, Suite 200, Bothell, WA 98011
Phone: (425) 415-4000 Fax: (425) 417-4795
e-mail: bsa@probusiness.com

(ProBusiness does not make any representation or warranty that the information contained in this newsletter, when used in a specific and actual situation, meets applicable legal requirements. This newsletter should not be construed as legal advice. Your legal counsel should be consulted on all specific fact situations.)

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