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Flexible spending accounts (FSAs) have been used since the 1980s as a supplemental benefit that employers can offer to employees. An FSA is a qualified employee benefit governed by Section 125 of the Internal Revenue Code (IRC), allowing plan participants to payroll-deduct salary on a pre-tax basis to pay for qualified out-of-pocket medical and daycare expenses. 

Participants can pay for these expenses on a pre-tax basis, thus increasing their take-home pay. The employee funds contributed to the account are deducted from earnings before taxes, lowering taxable income. As such, regular contributions to an FSA can significantly lower annual tax liability.

To the extent participants put money into these qualified plans through payroll deduction, taxable income is decreased, so less FICA (Federal Insurance Contributions Act, which includes Social Security and Medicare taxes) is paid. 

This article touches on a way to think about this employee benefit in the context of co-employment and COVID.



The Consolidated Appropriations Act (CAA) was signed at the end of 2020. It allows employers that sponsor health or dependent care FSAs to permit participants to roll over all unused amounts in these accounts from 2020 to 2021 and from 2021 to 2022. Employers may also allow employees to prospectively change their health or dependent care FSA contribution rates during 2021 without experiencing a permitted election-change event. It is important to note that employers can allow these changes by amending their plans, or they can choose not to incorporate these provisions. PEOs should consider participant needs and PEO financial impacts before making these changes. Employers wishing to offer optional FSA relief provisions must amend their Section 125 cafeteria plans to incorporate the changes. The amendment may be retroactive as long as it is adopted no later than the last day of the calendar year following the year in which the amendment is effective. 

Earlier in 2020, over-the-counter (OTC) medical expenses were re-instated for eligibility in health FSAs on a permanent basis. This had been removed previously by the Obama administration. 



For this qualified benefit to be available for the participants, certain steps need to be taken to keep the plan in compliance with IRS regulations. In the co-employment and administrative services only (ASO) environments, additional considerations require proper up-front documentation strategies and specialized ongoing administration to keep the PEO in good-faith compliance. Plans have annual testing requirements to ensure that key employees and highly compensated executives are not exceeding regulatory plan limits. Claims review requirements must be coordinated with evolving debit card technologies. Terminating employees are entitled to extend their health FSA availability under specific Consolidated Omnibus Budget Reconciliation Act (COBRA) rules. For PEOs, there are eligibility considerations for client-owners. While it may be tempting to allow S-Corp and LLC owners to participate in these benefits, this must be avoided for the plan to survive an IRS audit—special handling is required. PEOS are well-advised to seek trusted advisors with knowledge and experience in handling these benefits on their behalf. There is no substitute for experience.



Benefits of Section 125-based plans include:


Premium Accounts

The employees’ contributions toward group health plans are automatically run through the Section 125 plan on a pre-tax basis and the employer uses those monies to cover the employees’ portions of the group benefit plan premiums. 


Health FSAs

The 2021 limit that participants can contribute to health FSAs is $2,750 to cover expenses not covered by insurance, such as dental, vision, and many over-the-counter medications. Because health FSAs are governed by the Employee Retirement Income Security Act (ERISA), special compliance matters need attention, including making all annual funds available at the beginning of the plan year, limitations on mid-year election changes, and COBRA eligibility. Any plan sponsor’s goal is to keep the plan compliant with IRS regulations, so it is best to seek professional advice in plan design and administration to put your PEO in the best position to survive during an audit. IRS rules allow participants to carry over $550 of unused funds from one plan year to the next, and most PEOs incorporate this feature to foster greater plan participation.


Dependent Care Assistance Programs (DCAPs)

To assist dual working couples, DCAP allows for $5,000 per household to be contributed into the plan to cover daycare expenses on a pre-tax basis. Because this part of the benefit is not covered by ERISA, different rules apply to set-up and administration.


Health Savings Accounts (HSAs)

While HSAs are a separate account owned by the participant under specific eligibility rules, Section 125 plans can accommodate participant pre-tax contributions into their HSAs through payroll deduction, provided the Section 125 plan is properly set up and documented to allow that contribution. 


Adoption Assistance & Transportation Benefits

Other benefits can be added, including adoption assistance in the amount of $14,300 annually and transportation benefits up to $270 per month for qualified transit expenses and $270 per month for qualified parking expenses.


Debit Cards

Most flex plans use debit card technology, where a card is issued to pay for eligible plan expenses. While IRS rules require all purchases to be reviewed, there are exceptions whereby purchase eligibility is confirmed at the point of sale, meaning the card can be smart enough to know that the expenditure is allowed by the plan. Point-of-purchase technology is evolving. As of this year, about 88 percent of purchases made via debit card do not need to be reviewed; however, remaining purchases will likely require further documentation to confirm eligibility. Cards are becoming more integrated, so only one card needs to be issued for all accounts, including HSAs and transportation (transit and parking) benefits.



Section 125 plan flexible spending accounts are a great supplementary benefit PEOs can offer to their worksite employees, especially now.  If set up and administered correctly, both the participant and the employer/plan sponsor can enjoy significant tax savings. While the co-employment environment can offer unique additional challenges, proper handling by experienced advisors can ensure a successful experience. Get your plan tuned up and ready so you can expand your participant base.


This article is designed to give general and timely information about the subjects covered. It is not intended as legal advice or assistance with individual problems. Readers should consult competent counsel of their own choosing about how the matters relate to their own affairs.




PEO Auxiliary

Madison, Wisconsin


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