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May 13, 2020 | Benefits Management | Posted by Bob Greene, Senior HR Industry Analyst at Ascentis

IRS Announces Biggest Changes to Sec. 125 Provisions Since Their Inception

In the 42 years since IRC Section 125 became the law and revolutionized taxation of “fringe benefits” (as we quaintly used to call them), its provisions for pre-tax payment of health insurance premiums, as well as new insurance funding vehicles like flexible spending accounts, have become ubiquitous. Indeed, Sec. 125 provisions have been so widely adopted that you’d be hard-pressed to find an employer still requiring employees to pay for health plans with post-tax dollars.

The rules around Sec. 125 plans have always been strict, including restrictions requiring employees to make their health plan elections prior to the beginning of the applicable plan year, a requirement that those elections be effective for the entire plan year, and that election changes can only be made mid-year due to one of an enumerated list of “qualifying events.”

With the issuance of IRS Notice 2020-29 on May 12, 2020 (“COVID-19 Guidance Under § 125 Cafeteria Plans and Related to High Deductible Health Plans”) all that changed. At a high level, Notice 20-29 provides for three categories of temporary (calendar year 2020) changes:

  • Section 125 health insurance plans can now allow the following mid-year changes without requiring the employee to undergo a qualifying life event or significant change in the cost of coverage, as specified in Treas. Reg. § 1.125-4:
    • Employees may make a new election on a prospective basis if the employee previously declined coverage any employer-sponsored health coverage, OR
    • Employees may revoke an existing election and make a new election to enroll in different health coverage sponsored by the same employer on a prospective basis; OR
    • Employees may revoke an existing election on a prospective basis, provided that the employee attests in writing that he or she is enrolled, or immediately will enroll, in other health coverage not sponsored by the employer.
  • Section 125 healthcare or dependent care FSAs may now extend their claims runout (“grace” periods), which otherwise would have expired any time in 2020, to December 31, 2020.
  • The provisions of IRS Notice 20-15, allowing for reimbursement of COVID-related testing and treatment expenses before the deductible in a high deductible health plan (HDHP) is met, without disqualifying the employee’s plan from normally favorable tax treatment, are being made retroactive to January 1, 2020. Similarly, the provisions of § 3701 of the CARES Act (P.L. 116-136), allowing telemedicine services to be reimbursed before the deductible in an HDHP is met, are being made retroactive to January 1, 2020.

It should be noted that all of the § 125-revising provisions of Notice 20-29 are permissive rather than imperative. In other words, per the IRS, employers may adopt any or all of these provisions for their plans, but are not required to do so.

Why Make These Changes?

Commentators have theorized a number of scenarios under which employers would want to “take the IRS up on the offer” and make these changes to their plans. Under the first of these scenarios, an employer may be asking or requiring some of their employees to take a significant cut in pay to avoid layoffs. When this occurs, the employee who accepts the lower pay may wish to cut whatever expenses they can and health care FSA contributions might be one of those expenses. Another situation that might arise would be that an employee’s daycare provider becomes unavailable for an extended period (or permanently) for COVID-related reasons, and the employee therefore wants to scale back or discontinue dependent care FSA contributions.

But a third scenario foreseen by some analysts is a bit odd, and might not necessarily be something an employer wishes to “advertise.” These analysts forecast that employees may be hesitant to return to work, if they are concerned about virus infection, unless they have health insurance coverage (which, perhaps, they declined back in November when no one had heard of this virus) or a more robust level of contribution to a healthcare FSA. Obviously the messaging around this rationale must be carefully factored into an employer’s overall communications plan for ensuring their employees that their return to work in an office will be made as safe for them as possible.

Plan Amendments and Retroactivity

As noted above, many of these provisions are retroactive to January 1, 2020. The Notice also goes on to align these provisions with other CARES Act provisions governing changes to 401(k) plan distributions and loans from a plan amendment perspective. Specifically, noting that employers may be unusually busy right now addressing various impacts of the pandemic on their workforces, the Service extends the period of time employers have to adopt amendments to their Sec. 125 plans. The Notice gives employers until December 31, 2021 to adopt these amendments for plan year 2020, but they must notify employees eligible to participate in the plans immediately upon deciding to adopt these revised provisions.

Bob Greene currently serves as Senior HR Industry Analyst at Ascentis. Bob’s 40 years in the human capital management industry have been spent in practitioner, consultant and vendor/partner roles. As practitioner, he managed payroll for a 5,000-person bank in New Jersey. As consultant, he spent 8 years advising customers in HRMS, and payroll and benefits system design as well as acquisition strategies. Bob also built a strategic HCM advisory practice for Xcelicor (later acquired by Deloitte Consulting.)