How to Set Up an FSA for a Small Business
Unlock a valuable employee benefit. This guide helps small businesses confidently establish and manage a tax-advantaged Flexible Spending Account.
A Flexible Spending Account (FSA) allows employees to set aside pre-tax money for specific expenses, reducing their taxable income. This article guides small business owners through establishing an FSA for their employees.
Key Considerations for Setting Up an FSA
Before implementing an FSA, small business owners should understand the two types: Health Care FSAs and Dependent Care FSAs. A Health Care FSA covers eligible medical, dental, and vision expenses not reimbursed by health insurance, such as deductibles, co-payments, and prescription medications. A Dependent Care FSA helps employees pay for care services for qualifying dependents, including children under age 13 or dependents of any age incapable of self-care.
Employers must establish an FSA under a Section 125 Cafeteria Plan. This plan allows employees to choose between taxable benefits and qualified non-taxable benefits, such as FSAs, on a pre-tax basis. Pre-tax FSA contributions are exempt from federal income, Social Security, and Medicare taxes for employees, also reducing the employer’s payroll tax liabilities.
Annual contribution limits apply to both types of FSAs, as set by the IRS. For Health Care FSAs, employees can contribute up to $3,300 in 2025 through payroll deductions. If a spouse has a separate Health Care FSA through their employer, they can also contribute up to this amount, potentially allowing a household to contribute up to $6,600. The Dependent Care FSA has a separate limit, set at $5,000 for individuals or married couples filing jointly, or $2,500 for married individuals filing separately for the 2025 tax year.
The “use-it-or-lose-it” rule dictates that any unused FSA funds are forfeited at the end of the plan year. However, employers can offer exceptions. One exception is a grace period, allowing employees up to an additional 2.5 months after the plan year ends to incur new expenses and use remaining funds.
Alternatively, employers may offer a rollover option for Health Care FSAs, allowing a portion of unused funds to be carried over to the next plan year. For plan years ending in 2025, the maximum rollover amount is $660. An employer cannot offer both a grace period and a rollover.
Establishing Your Flexible Spending Account Plan
Selecting a Third-Party Administrator (TPA) or FSA provider is a common approach for small businesses. TPAs specialize in administering these plans, handling claims processing, compliance support, and participant communication materials.
When choosing a TPA, inquire about their experience with similar businesses and their services for IRS compliance. A TPA can assist in designing the FSA plan, including decisions on rollover or grace period features. These choices influence the plan’s structure and operational rules outlined in formal plan documents.
Formal plan documents are legally required for an FSA, including a Section 125 Cafeteria Plan document and a Summary Plan Description (SPD). The Section 125 document outlines benefits and rules for employee elections, ensuring tax compliance. The SPD provides employees with an overview of the plan’s terms, conditions, and operations.
The TPA assists in drafting these documents to meet regulatory requirements. Once finalized, communicate the FSA plan to employees. This involves providing clear information about benefits, eligibility, contribution limits, and enrollment.
Employee enrollment occurs during an annual open enrollment period, where employees make elections for the upcoming plan year. These elections are generally irrevocable for the plan year unless a permitted election change event occurs, as outlined in IRS regulations.
Managing Your Flexible Spending Account
Once the FSA plan is established, ongoing management and compliance are the employer’s responsibility. The employer accurately deducts employee contributions from payroll on a pre-tax basis. These funds are remitted to the TPA or FSA provider, who manages individual employee accounts.
Employees submit claims for eligible expenses to the TPA, often with supporting documentation like receipts. The TPA reviews these claims to ensure they meet IRS guidelines for qualified expenses and processes reimbursements from the employee’s FSA balance.
Maintaining accurate records is also important for the employer. This includes keeping track of employee elections, payroll deductions, and all contributions made to the FSA accounts. These records are necessary for internal accounting, potential audits, and to ensure proper reporting.
Compliance requirements, such as non-discrimination testing, are a regular part of FSA management. These tests are mandated by the IRS to ensure that the plan does not disproportionately favor highly compensated employees or key employees regarding eligibility, contributions, or benefits. TPAs frequently assist with performing these annual tests, which are typically conducted within 60 days of the plan year’s end.
Failure to pass non-discrimination testing can result in the benefits becoming taxable for highly compensated employees.
Some FSA plans may also have annual reporting requirements, such as filing Form 5500 with the Department of Labor. However, many small welfare benefit plans, including FSAs, are exempt from this filing if they cover fewer than 100 participants at the beginning of the plan year and are unfunded or fully insured. It is advisable for employers to verify if their specific plan qualifies for this exemption.