The IRS recently issued clarifications on the Heroes Earnings Assistance and Relief Tax Act of 2008 (the HEART Act) which became law on June 18, 2008. This Act allows, but does not require, distributions from a pre-tax health flexible spending account (health FSA) to employees who leave for active military duty. This article contains a summary of the new IRS guidance issued in Notice 2008-82. For sake of this article, we will refer to a qualified reservist distribution (QRD) as a "distribution."

Eligible Participants and Required Documentation

Eligible participants are members (or have a spouse who is a member) of a reserve component ordered to active duty for 180 days or more or for an indefinite period. Multiple orders can be accumulated to meet the 180-day requirement. An employee/spouse called to duty before June 18, 2008 is eligible for distributions if the active duty continues after June 18, 2008 and meets the 180-day rule. "Reserve component" means: Army, Army National Guard, Air Force, Air National Guard; Navy, Marine Corps, Coast Guard, or the Reserve Corps of the Public Health Service.

The employer must require a copy of the orders to determine if the employee is eligible for a distribution. As long as the call/order is for 180 days or more, the employee may request a distribution even though he/she may not serve for the entire duration.

Qualified Reservist Distribution - Eligible Amount

The employer determines the eligible distribution amount, selecting from the following options:

1. The entire plan year election for the health FSA minus reimbursements received as of the date of the distribution request. With this option, the employer could potentially have to pay out more than the participant has contributed.
2. The amount the participant has actually paid into the plan less their reimbursements as of the date of the distribution request. Participants who have already spent at least what they have contributed will not be eligible for a distribution. This option is the least costly to employers.
3. Some other amount not to exceed the entire health FSA plan year election minus reimbursements. This option may not be used frequently as the employer will have to create their own formula.

• in existence prior to June 18, 2008
• forfeited on or before June 18, 2008
• attributable to a prior plan year, or
• attributable to a non-health FSA.

Number of Distributions

Employers will need to decide how many distributions a participant can receive each plan year.

Health FSA Claims

Prior to a distribution, the plan must continue to pay all eligible claims under normal operating procedures. The IRS guidance currently indicates that health care claims incurred before but submitted after the distribution date must be paid, even though the participant has received a distribution. We hope to receive further guidance on this issue.

For medical expenses incurred after the distribution date, the employer will have two options:

1. Allow employees to continue to submit claims incurred before the end of the plan year or the grace period. The employer must determine whether or not they want to continue to pay claims out of company assets.
2. Terminate an employee's right to submit claims.

Timing of Distributions

The participant must request the distribution between the date of the call or order to active duty and the last day of the plan year (or grace period if applicable). The employer must pay the distribution within a reasonable time, but no later than 60 days after the request is made.

Taxation of Qualified Distributions

A qualified reservist distribution is includable in the employee's taxable gross income, is subject to employment taxes and is reported on Form W-2 for the year the distribution is paid to the employee. For example, if the plan contains a grace period, and a distribution is made in January 2009 for 2008 FSA contributions, it is taxed in 2009. The amount reported as wages is reduced by any amount in the health FSA that consists of after-tax contributions (i.e. COBRA payments). Most likely, these distributions will need to be made through payroll rather than by the FSA Administrator for taxation to be correct, so the employer needs to coordinate closely with the FSA Administrator.

Nondiscrimination Issues

An employer implementing the distribution rules must apply them consistently to all plan participants. Distributions are not included in the annual cafeteria plan nondiscrimination testing.

What Happens When the Employee Returns?

The IRS did not provide guidance in Notice 2008-82 about employees' options when they take a distribution and then return from active duty, especially within the same plan year. The cafeteria plan "election change" rules should be analyzed when the employee returns from active duty. Because the employee may be able to participate immediately upon return, it is easier to manage the implications if the employer caps the distribution amount at the amount already contributed minus paid-out claims (Option 2, discussed above).

Plan Must Be Amended but Relief Provided

An employer may begin allowing distributions without an amendment in place as long as the plan is amended on or before December 31, 2009. The amendment must be effective retroactively to the date of the first qualified distribution but not prior to June 18, 2008. For employers implementing after 2009, the amendment must be in place prior to making the first distribution.

Implementing These New Rules

There are several administration issues to address when considering allowing HEART distributions. Document providers are working on their HEART amendments. Even though an amendment is not required until next year, employers adopting the HEART provisions will need to create participant communications to explain it to affected participants.