In general, Flexible Spending Account programs can create financial situations where the total amount collected from participants either exceeds amount spent by plan participants, or is less than the total amount spent. This article is intended to provide a brief overview of these situations and in general how they can be accounted for and reconciled.
Note, Superior State is not intending to provide tax advice, rather familiarity with the financial situations that may occur and common remedies. You should always review any approach with appropriate tax professional(s).
EMPLOYEE FORFEITURES
Because, in general, with the use-it or lose-it nature of FSA programs, there are/can be common situations where an employee (or employees) will not spend their entire election amount in the given plan year. Optional employee plan features such as the Carryover or Grace Period can reduce the likelihood of employee forfeitures, but even these participant friendly features don't guarantee that an employee may forfeit funds to the plan.
When such forfeitures occur for a given plan year, there are two general types of remedies: 1) return funds to plan participants, 2) record the forfeitures as a reduction of your business expenses associated with sponsoring such a plan.
Returning Funds to Participants
These plans are use-it or lose-it, however, there are approaches to returning funds to plan participants. Note, if there is only one participant in the plan, these solutions will not be appropriate. However, in multi-participant plans, a refund of the total amount of employee forfeiture is allowed at plan year end if it is done in one of two ways:
1) Return equal share to all plan participants. For example, you have 5 plan participants, one of the participants has a forfeiture of $1,000. You return $200 as taxable income to each of the 5 plan participants.
2) Return equal proportion of forfeiture to participants based on election amounts. Similar example, 6 plan participants, 2 elected $1,000 per year, 2 elected $1,500 per year, 2 elected $2,000 per year ($9,000 total participation). Total participant forfeitures are $900 for the year. Ratio is based on election, so those who elected $1,000 get 1,000/9,000 or 1/9th of the $900 forfeiture ($100). Those who elected $1,500 get 1,500/9,000, or 1/6th ($150) and so on.
Reducing Business Expenses
This is the most common method of accounting for forfeitures. It basically reduces the overall business expenses associated with running the plan by offsetting or creating credits in expense accounts associated with the plan. There are 3 main types of expenses to offset:
1) Plan Overspending. Some participants may spend more than they put in and then terminate before fully funding their plan. Such overspending will create additional expense on the plan that is relieved (offset) by the plan forfeitures of another participant.
2) Outsourcing Expenses. Superior State charges fees to administer your plan each year, such fees are expensed to a certain billing account. Perhaps there are other fees associated with running the plan. Applying the forfeitures as negative expense to such accounts is appropriate, as it just reduces your overall fees and increases your businesses taxable income.
3) Internal Labor Cost Reduction. After offsetting the first two items, if there are still forfeitures in excess of such costs, you are able to offset against the reasonable internal labor costs associated with the HR and other employees involved in making the plan work internally. This amount should be a reasonable amount and documented with justification of your costs assumed.