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IRS issues guidance on flex benefit plans

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WASHINGTON—Proposed Internal Revenue Service regulations provide employers specific guidance for the first time on certain practices for operating and administering Section 125 flexible benefit plans, consultants say.

Because the IRS is likely to use the guidance as a springboard for future audits, its proposed regulations also are likely to bring greater uniformity among employer practices, consultants add.

The proposed rules, released Aug. 3, apply to the wide array of coverages offered through flexible benefit plans. Those benefits can include health insurance, flexible spending accounts, health savings accounts, disability coverage, group term life insurance and dependent care benefits.

While providing new guidance, the IRS also generally confirms that employers should continue many "good faith" practices they have adopted so far, the consultants said.

"It's always good when you get definitive guidance one way or the other so you know how you are doing," said J.D. Piro, an attorney at Hewitt Associates Inc. in Norwalk, Conn. "It is even better when it confirms the direction you have been going and it doesn't require major course correction."

The regulations tell employers practices that should be spelled out in their plan documents, consultants said.

The regulations retain, as expected, an earlier IRS rule that requires employees to forfeit unused FSA balances at the end of the plan year or 2½ months after the close of the plan year if a so-called grace period feature is adopted. However, the rules make clear that employers can use remaining balances to pay for administrative expenses they incur in offering FSAs.

Employers forged existing administration and operations practices by attempting to follow IRS proposed regulations in 1984 and 1989. But those pronouncements lacked specific direction and tax law changes have occurred since, observers added.

A significant area of guidance focuses on testing flexible benefit plans to assure they do not discriminate in favor of highly compensated employees and against employees that are not highly compensated, said Sharon Cohen, group and health benefits council for Watson Wyatt Worldwide in Arlington, Va.

Employers that have already implemented measures they hoped would eliminate that possibility relied on a "very general discussion" of nondiscrimination rules to follow, Ms. Cohen said.

Several consultants agree.

"Section 125 has been in the Internal Revenue Service code since 1978, and this is really the first time the Service has provided substantive, interpretive guidance on these nondiscrimination rules," said Mike Langan, a principal at Towers Perrin in Valhalla, N.Y.

The regulations do not create new tests for areas such as plan eligibility or election of contributions and benefits. But the IRS does clarify how to conduct the tests.

To test for nondiscriminatory eligibility, the IRS confirms that it is appropriate to rely on rules already established for qualified retirement plans under its code section 410(b). Additional guidance on objective testing to determine whether contribution and benefit election practices are discriminatory includes a specific formula or ratio to measure use among employees, Ms. Cohen said.

The IRS proposes that its rules apply for plan years beginning Jan. 1, 2009. But it wants public comment before finalization, and it said it will hold hearings on Nov. 15. Taxpayers, however, may rely on the new regulations pending the final rules, the IRS said. When the IRS finalizes its regulations, it will use them to audit employers' flexible benefit plans, it added.

Because the IRS has not provided substantive interpretation or guidance on nondiscrimination tests before, enforcement has been lax, Mr. Langan said.

Other consultants say some employers either haven't tested or their tests have been perfunctory.

"The sea change here is that the Internal Revenue Service has not only issued this interpretive guidance, but that they seem to have signaled that they are going to move forward over the next several years and perhaps enforce these rules," Mr. Langan said.

While the new regulations are more specific than what employers have had to work with in the past, some ambiguities remain and are likely to draw public comment and future changes, the consultants said.

In addition to nondiscrimination testing, the proposed regulations address a host of issues including debit cards, paid time off, 401(k) plan contributions and what constitutes a flexible benefit plan year.

For instance, they definitively require that a flexible benefit plan year must be 12 months--a practice employers generally but not always have adopted, consultants said.