May 25, 2017
Q: We recently learned about some mistakes that were made administering our company’s cafeteria plan. For example, we discovered a few health flexible spending account (FSA) and dependent care assistance program (DCAP) expense reimbursement errors, and a couple of employees not having the right salary reduction amounts withheld. Should we correct mistakes like these?
In general, if there has been a mistake in administering a cafeteria plan, the mistake should be corrected so that the plan and the participants are put back into the position they would have been in had the mistake never occurred.
Under proposed IRS cafeteria plan regulations, an operational or documentation error can cause the entire cafeteria plan to be disqualified. The regulations offer examples of operational failures, including failure to comply with the “use-it-or-lose it” rule and payment of an ineligible expense from a flexible spending arrangement. According to the regulations, a plan that fails to operate in accordance with its terms or otherwise fails to comply with the Internal Revenue Code or regulations “is not a cafeteria plan,” and employees’ elections between taxable and nontaxable benefits result in gross income to employees.
The maximum penalty would be to treat the plan as if it didn’t exist — in other words, disqualify the plan and impose on the employer employment tax withholding liability and penalties for all employee pre-tax and elective employer contributions. Employees could also be required to pay employment and income taxes and penalties on their pre-tax and elective employer contributions. Errors in violation of ERISA, COBRA, and HIPAA could also expose a sponsor to damages from private lawsuits as well as penalties.
While the IRS may have the power to impose the maximum penalties for an infraction, what it actually would do is likely to depend on the facts and circumstances. Reasonable good faith efforts to bring a plan into prospective compliance while doing whatever is possible to reverse past errors will put the plan in the best position to reduce or even avoid tax penalties. Note that little guidance exists to help employers correct mistakes under cafeteria plans, health FSAs, or DCAPs.
IRS publications provide some guidance in a few narrow areas, but that guidance is quite limited. And there are no standardized correction programs for cafeteria plans similar to those that are available for qualified retirement plans. For this reason, many cafeteria plan sponsors seek the advice of tax advisors, benefits counsel or other advisors when deciding how to address mistakes in plan administration.