What happens to health FSA balances when an employer acquires another entity?

Business reorganizations are complex transactions that can impact benefit administration in a variety of ways. One common issue concerns handling health FSA balances of acquired employees.

If health FSA terms are not negotiated during the transaction, certain default rules apply depending upon whether an asset or stock purchase occurred. An asset purchase occurs when the buyer purchases some or all of the seller’s assets (and may also be assuming certain liabilities). Employees of the purchased entity would normally be considered terminated employees of the seller. However, these employees will often be rehired by the buyer. In contrast, a stock purchase occurs when a buyer purchases all of the stock or ownership in the seller’s business (or a unit thereof). Employees of the purchased business would continue to be employed by the same legal entity; however, the ownership of that entity is transferred from seller to buyer.

With an asset purchase, this typically results in termination of the former employee’s participation in the seller's health FSA and the possibility of a health FSA forfeiture (and COBRA rights). However, the IRS provides two ways the existing balances under the seller’s plan can transfer following the closing date of the transaction. One option allows the buyer to cover the rehired employees under its health FSA for the remainder of the plan year. The employees' account balances (whether underspent or overspent) under the seller's health FSA are rolled over to the buyer's health FSA. The other option is that the parties could agree to have the rehired employees continue to participate in the seller’s health FSA plan for a period of time, such as the end of the plan year.

If the transaction is a stock purchase, then the default rules are a little different. In the instance where the acquired business maintains its own cafeteria plan and the plan is continued following the transaction, the acquired employees' health FSA elections would continue uninterrupted. Alternatively, the plan could be terminated prior to the transaction closing. In this event, acquired employees should be given as much advance notice as possible so that they have an opportunity to use account balance and avoid forfeitures. Generally, there will be no COBRA rights in this instance because there is no termination of employment and therefore no COBRA qualifying event.

Additionally, informal guidance from the IRS indicates that employees of the acquired business are permitted to be brought into the buyer's cafeteria plan midyear (at the time of the closing) with the same level of health FSA coverage and the same salary reduction elections as they had under the acquired company’s cafeteria plan at the time of the sale. In this situation, the buyer would have to make appropriate amendments to its plan.

The agreed upon approach for the transition should be incorporated in the purchase agreement, so each party’s obligations are clearly defined. Cafeteria plan amendments will likely also be necessary, as will clear communication with employees. Importantly, while the IRS provides default rules for health FSAs and business reorganizations, employers should consult with counsel on this matter.