FSA Compliance: Contribution Limits, Testing, and Reporting

Meeting FSA compliance requirements means maintaining a written Section 125 cafeteria plan document, running elections and reimbursements the way the IRS prescribes, substantiating every claim, and passing annual nondiscrimination testing. Get any of it wrong and the consequences range from reclassified income for a handful of executives to a full loss of tax-advantaged status for every participant. FSA contributions escape federal income tax, Social Security tax, and Medicare tax, which is why the IRS regulates them so tightly.¹

Start With a Written Plan Document

Section 125 defines a cafeteria plan as a “written plan.” The document is not optional.² It must describe the benefits offered, set eligibility rules, and lay out election procedures.³ It also needs to specify the plan year, the contribution limits the employer has adopted, and whether unused funds get a grace period or a carryover.

If salary reductions flow through an arrangement that has no valid written plan, the IRS treats it as if no cafeteria plan exists. Every dollar an employee diverted becomes taxable wages, and the employer owes the associated employment taxes on all of it. This is the single failure mode that reaches every participant rather than just the executives.

Separately, plan administrators must give each participant a Summary Plan Description free of charge, explaining how the plan works, when employees become eligible, and how to file a claim.⁴ Federal regulations require the SPD to be “written in a manner calculated to be understood by the average plan participant.”⁵

2026 Contribution Limits

For the 2026 plan year, health FSA salary-reduction contributions are capped at $3,400 per employee, up from $3,300 in 2025.⁶ Dependent care FSA limits for 2026 sit at $7,500 for employees who are single, head of household, or married filing jointly, and $3,750 for those married filing separately.⁷ Write these ceilings into the plan document. Setting an election ceiling above the IRS maximum creates a compliance problem for every affected participant.

Elections Are Locked, With Narrow Exceptions

Employees choose their contribution amount during open enrollment, and that election is irrevocable for the full plan year. Mid-year changes are permitted only when a specific qualifying event occurs and the change is consistent with that event.⁸

Treasury Regulations recognize these qualifying events:

Change in marital status: marriage, divorce, legal separation, annulment, or death of a spouse
Change in number of dependents: birth, death, adoption, or placement for adoption
Change in employment status affecting the employee, spouse, or dependent: termination, new job, strike, lockout, unpaid leave, or worksite change
Dependent eligibility change: a dependent aging out of coverage or gaining or losing student status
Change in residence for the employee, spouse, or dependent
Medicare or Medicaid entitlement gained or lost by the employee, spouse, or dependent

The consistency requirement matters. An employee who divorces can drop spousal coverage, but the divorce is not a basis for doubling the health FSA election.⁸

Substantiate Every Claim

Every FSA reimbursement must be backed by documentation from an independent third party. The IRS has been explicit: employees cannot self-certify that an expense is eligible, and employers cannot skip substantiation on small-dollar claims or rely on spot-checking a sample. All claims require verification, regardless of amount. Acceptable proof usually means an Explanation of Benefits from an insurer or an itemized receipt showing the date, amount, and nature of the service.

Benefits debit cards can automate part of this. Pharmacies and retailers participating in the Inventory Information Approval System flag eligible items at the point of sale, so those purchases clear without a follow-up receipt. Charges that are not auto-verified require the plan administrator to request supporting documentation from the cardholder.

When an employee receives reimbursement for an ineligible expense or cannot produce substantiation on request, the reimbursement loses its tax-free status under Section 105(b). The amount goes into the employee’s taxable income, and the employer must report it and withhold employment taxes. Card-based plans generally offset the unsubstantiated amount against future eligible claims or request direct repayment.

Use-It-or-Lose-It, Grace Period, and Carryover

FSA funds not spent by the end of the plan year are forfeited. The IRS calls this the use-or-lose rule, and it applies to both health and dependent care accounts.⁹ Employers can soften it with one of two options, but not both for the same benefit:

A grace period of up to two months and 15 days after the plan year ends, during which participants can incur new expenses against the prior year’s balance.⁹
A carryover of unused health FSA funds into the next plan year, capped at $680 for the 2026 plan year.¹⁰

Whichever option a plan chooses must be written into the plan document before the plan year begins.

The Uniform Coverage Rule

Under the uniform coverage rule, the full annual health FSA election must be available to the employee from the first day of the plan year, regardless of how much has actually been deducted from paychecks. An employee who elects $3,400 and incurs a $3,400 medical expense in January, after a single biweekly deduction, is entitled to full reimbursement immediately.

The exposure surfaces at termination. An employee who resigns in March after being reimbursed $3,400 but contributing only $600 through payroll leaves a $2,800 shortfall the employer cannot recover. No deduction from the final paycheck, no bill to the former employee, no offset against other benefits. That loss is the cost of offering a health FSA, and it is baked into the regulatory structure: without it, the arrangement would not qualify as a health FSA under proposed Treasury Regulations.

The uniform coverage rule does not apply to dependent care FSAs. Those accounts reimburse only up to the amount contributed to date, so the timing risk sits with the employee.

Nondiscrimination Testing

FSA nondiscrimination testing exists to keep plans from becoming an executive perk. The tests differ depending on whether you are looking at a health FSA, a dependent care FSA, or the Section 125 cafeteria plan itself.

Who Counts as Highly Compensated or Key

For 2026, a highly compensated employee is anyone who earned more than $160,000 in the prior year, or, at the employer’s election, was in the top 20% of earners. A key employee is an officer with annual compensation above $235,000, a more-than-5% owner, or a more-than-1% owner earning over $150,000.¹¹ These thresholds decide whose benefits are at risk when a test fails.

Health FSA Tests

A health FSA is a self-insured medical reimbursement plan and must satisfy Section 105(h). Two tests apply. The eligibility test bars discrimination in favor of highly compensated employees in deciding who participates. The benefits test bars richer or more generous benefits for highly compensated employees than for the rest of the workforce.¹²

Dependent Care FSA Tests

Dependent care accounts face a stricter battery of tests under Section 129(d):¹³

An eligibility test that bars discrimination in favor of highly compensated employees or their dependents in deciding who can participate.
A 55% average benefits test: the average benefit provided to non-highly-compensated employees must be at least 55% of the average benefit provided to highly compensated employees.
An owner concentration test: no more than 25% of the total dependent care assistance paid by the employer during the year can go to individuals who own more than 5% of the business.

The 55% test trips up more employers than expected, especially at smaller companies where a few high-earning participants skew the averages.

Section 125 Key Employee Concentration

Layered on top, the cafeteria plan itself has a rule of its own: qualified benefits provided to key employees cannot exceed 25% of the aggregate qualified benefits provided to all employees under the plan.² At a small company with a few officers, this cap is easier to hit than it looks.

What Happens When Something Fails

A common misconception is that a failed nondiscrimination test blows up the plan for everyone. It doesn’t. A Section 105(h) failure means excess reimbursements paid to highly compensated employees lose their tax-free status and become taxable income to those individuals.¹² A Section 125 concentration failure hits key employees the same way. Rank-and-file employees keep their tax benefit.²

The correction burden still lands on the employer, though. The company must reclassify the affected amounts as taxable income, report the change on W-2s, and withhold or pay the corresponding employment taxes.

The truly catastrophic scenario is different: an employer running salary reductions without a valid written plan document. Because Section 125 conditions cafeteria plan status on a written plan, there is no cafeteria plan at all in that situation. Every salary reduction becomes taxable to every participant, and the employer owes back employment taxes on the whole population. This one is preventable with documentation.

Reporting Obligations

Dependent care FSA benefits must be reported on the employee’s W-2 in Box 10, regardless of amount. A cafeteria plan that offers only FSAs generally does not need to file Form 5500 with the Department of Labor. If the FSA is part of a larger welfare benefit plan covering 100 or more participants, Form 5500 may be required. DOL penalties for failing to file a required Form 5500 can reach $2,739 per day with no maximum cap, which makes a missed deadline one of the most expensive administrative oversights in benefits compliance.

1
Internal Revenue Service. Eligible Employees Can Use Tax-Free Dollars for Medical Expenses
2
Office of the Law Revision Counsel. 26 U.S. Code 125 – Cafeteria Plans
3
Internal Revenue Service. FAQs for Government Entities Regarding Cafeteria Plans
4
U.S. Department of Labor. Plan Information
5
eCFR. 29 CFR 2520.102-3 – Contents of Summary Plan Description
6
FSAFEDS. Message Board
7
FSAFEDS. Dependent Care FSA
8
eCFR. 26 CFR 1.125-4 – Permitted Election Changes
9
Internal Revenue Service. IRS Notice 2013-71 – Modification of Use-or-Lose Rule for Health Flexible Spending Arrangements
10
Erisa Practice Center. IRS Releases Annual Increases to Health FSA and Transportation Fringe Benefit Limits for 2026
11
Internal Revenue Service. Amounts Relating to Retirement Plans and IRAs, as Adjusted for Changes in Cost-of-Living
12
Office of the Law Revision Counsel. 26 U.S. Code 105 – Amounts Received Under Accident and Health Plans – Section: Amount Paid to Highly Compensated Individuals Under a Discriminatory Self-Insured Medical Expense Reimbursement Plan
13
Office of the Law Revision Counsel. 26 U.S. Code 129 – Dependent Care Assistance Programs