Changing a plan year is often viewed as an administrative exercise, but the health and welfare benefit compliance implications can be more complex than employers expect. When an employer utilizes a short plan year to transition between two 12-month plan years, it must navigate compliance considerations before, during, and after the transition. Short plan years can disrupt employee expectations, accelerate filing deadlines, and trigger special rules under ERISA, the Internal Revenue Code, COBRA, and the ACA. This observation presents a fictional case study to demonstrate some common compliance considerations associated with operating a short plan year to transition to a calendar year plan. More nuanced technical issues, such as HDHP deductible proration and nondiscrimination testing in a short plan year, are beyond the scope of this discussion.
Case Study
Sky Crafts Inc. operates a regional chain of craft supply stores with a large number of variable-hour employees. A decade ago, Sky Crafts had a handful of storefronts and began offering benefits to its employees on a plan year that runs from November 1 through October 31. Sky Crafts maintains a corporate headquarters and has grown nationally, quickly and steadily over the years. It is now an applicable large employer (ALE) subject to the ACA’s employer mandate. To comply, it uses the look-back measurement method to determine which employees must be offered coverage. Sky Crafts applies 12-month measurement and stability periods, with an intervening administrative period to calculate hours and extend offers of coverage. The stability period begins on November 1 to align with its current plan year.
Sky Crafts administers a self-insured medical plan. It also offers a health flexible spending arrangement (FSA) and a dependent care assistance program (DCAP). These benefits are offered on a pre‑tax basis through a Section 125 cafeteria plan. A wrap document bundles the self-insured medical plan and health FSA into a single ERISA plan, and Sky Crafts files a Form 5500 because its plan covers more than 100 participants each year.
The plan year that once worked for a leaner operation no longer suits Sky Crafts. Instead, Sky Crafts wants to move to a calendar-year plan cycle to better align enrollment timing, reporting deadlines, ACA administration, and other core compliance requirements. Because the end of its current plan year and the start of its intended new plan year are short – only two months apart – Sky Crafts wants to extend its current plan year to 14 months, keep employee elections in force, and then begin its new plan year on January 1.
The Necessary Short Plan Year Layover
Sky Crafts’ proposal to extend its current plan year will not get off the ground. Under IRS guidance, a cafeteria plan year generally must consist of 12 consecutive months, though a short plan year is permitted for a valid business purpose. Although Sky Crafts’ desire to simplify administration and compliance is likely a valid business purpose, extending coverage to a 14-month period will not work. Instead, Sky Crafts will need to operate a short plan year to facilitate the transition. For example, Sky Crafts could administer a short plan year from November 1 through December 31 to bridge its existing plan year (November 1) to a January 1 calendar year cycle.
Avoiding Missed Connections: Managing Health FSAs and DCAPs During the Layover
A short plan year will have special implications for Sky Crafts’ health FSA and DCAP. While the IRS publishes annual limits for health FSAs, those limits apply per plan year. For a short plan year, IRS guidance requires an employer to prorate the annual limit based on the number of months in the plan year. If Sky Crafts administers a two-month plan year, the maximum salary reduction contribution to the health FSA is two-twelfths of the published annual limit. Annual DCAP contribution limits, on the other hand, are based on the calendar year. An employee’s DCAP contributions in the short plan year, combined with those made in January through October, generally may not exceed $7,500 if single or married filing jointly, or $3,750 if married filing separately.
In addition, health FSAs and DCAPs generally are subject to the use-it‑or‑lose-it rule, and they may only reimburse eligible expenses incurred during the plan year (subject to a carryover or grace period for a health FSA, if applicable). For Sky Crafts’ health FSA and DCAP short plan years (which do not include a carryover or grace period), only expenses incurred in November and December would be reimbursable.
Providing health FSA and DCAP benefits during short plan years might create disproportionate administrative complexity for employers and confusion for employees, particularly when employees are asked to make elections and manage balances for a brief transition period. Employers weighing whether to offer these benefits during a short plan year may consider the length of the transition period, employee demographics, and expectations around spending account availability and timing. In some cases – particularly where the short plan year is brief – temporarily suspending these benefits during the transition may be a reasonable trade‑off, even though employees may forgo some benefits they anticipated. Advance communication can help manage employee expectations and minimize friction.
Selecting Seat Assignments: Open Enrollment
Additionally, Sky Crafts cannot automatically extend existing employee elections into the short plan year. Cafeteria plan regulations provide that employees must be given the opportunity to make elections at least once each plan year, and short plan years are no different. Sky Crafts should prepare to administer open enrollment ahead of the short plan year and again for the January 1 plan year. In addition, COBRA-qualified beneficiaries have independent open enrollment rights and must also be permitted to change health coverage elections to the same extent as similarly situated active employees.
Employers should address COBRA open enrollment details with their COBRA vendors to ensure that qualified beneficiaries are given the appropriate opportunity to make elections for the upcoming plan year. COBRA failures can lead to costly litigation and have historically been an enforcement priority for the DOL.
Snakes on a Plane: COBRA Rerating
Sky Crafts should also consider when to rerate COBRA premiums. Under COBRA, the applicable premium must be fixed for a 12-month determination period. However, it may be permissible for employers to select a new 12-month determination period if supported by a business reason or plan year change, so long as the employer intends to use the new 12-month determination period indefinitely.
In practice, employers typically set COBRA premiums annually ahead of the start of each plan year. If Sky Crafts were to recalculate the applicable premium ahead of the November 1 short plan year, it would not be permitted to rerate COBRA premiums again two months later when its next plan year begins. Note, however, that Sky Crafts could reset COBRA rates ahead of its new January 1 plan year and apply that 12‑month determination period indefinitely going forward.
For employers with fully insured plans, a short plan year does not necessarily change the underlying policy year or corresponding premium calculation. Misaligned policy and plan years may cause undue administrative burdens and disruption to participants (for active employees and COBRA beneficiaries alike). Employers should discuss with carriers whether it would be beneficial to align policy years with plan years, so that renewal rates take effect with open enrollment for a new plan year and corresponding COBRA determination period. For more information on calculating COBRA premiums, please ask your broker or consultant for a copy of the NFP publication COBRA: A Guide for Employers.
Fitting Into the Overhead Bin: ACA Look-Back Measurement Method
Because Sky Crafts uses the look-back measurement method to comply with the ACA’s employer mandate, it should evaluate whether to retain its existing measurement, administrative, and stability periods or modify them to better align with the intended January 1 plan year. For instance, Sky Crafts’ current November 1 stability period aligns changes in eligibility for medical coverage with its current November 1 plan year. Once Sky Crafts transitions to a January 1 plan year, however, retaining that stability period could result in employees gaining or losing eligibility during the middle of the plan year, requiring offers of coverage and terminations of coverage outside open enrollment.
If Sky Crafts decides to change its measurement, administrative, and stability periods, the ACA generally prohibits an employee from losing full-time status during an ongoing stability period solely as a result of the change. To address this limitation, Sky Crafts could operate its existing measurement and stability periods alongside new measurement and stability periods that align with the January 1 plan year. During this transition, employees must be measured under both structures until they complete an entire cycle under the new measurement period.
Aligning plan eligibility with look-back measurement periods can simplify administration and reduce ACA employer mandate penalty risk. Employers should ensure eligibility rules, along with their interaction with employer mandate measurement periods and COBRA maximum coverage periods, are clearly reflected in the plan document and approved by carriers, as well as stop-loss carriers for self-insured plans. For more information on administering the look-back measurement method, please ask your broker or consultant for a copy of the NFP publication ACA: Employer Mandate Measurement Methods.
Arriving at the Gate: Amending Plan Documents and Preparing Enrollment Materials
Once Sky Crafts settles on a path forward – but before beginning a short plan year – it should take formal steps to document the transition, including amending plan documents and preparing open enrollment materials. Because a Section 125 cafeteria plan document must specify the plan year on which it operates, Sky Crafts should formally amend that document to reflect the short plan year and the plan year change going forward. Its health FSA and DCAP plan documents should also be amended to reflect the revised plan year and applicable election limits.
If Sky Crafts decides to change its measurement, administrative, and stability periods, it should amend its ERISA plan document and summary plan document (SPD) to describe these new periods. ERISA plan documents and SPDs generally must include information about plan eligibility, meaning employers that use look-back measurement periods should detail the measurement and stability periods in these documents.
Sky Crafts should also prepare appropriate enrollment materials, benefits guides, and other employee communications in advance of open enrollment for the short plan year and the January 1 plan year.
This Is Your Captain Speaking: Communicating Changes to Employees
Transitioning to a new plan year does not have to be a heavy lift, but keeping the transition smooth requires strategic planning and clear employee communications well ahead of the change. Sky Crafts should be prepared to inform employees on what to expect ahead of both the short plan year and the January 1 plan year. Because 12-month plan years are standard – and generally required except in limited circumstances, as discussed above – a short plan year can be confusing if employees are not given advance notice of deadlines, the abbreviated coverage period, and the significance of their elections.
A short plan year represents a break from the usual annual enrollment cycle, requiring employees to make elections twice in close succession and shortening coverage periods for account-based benefits such as health FSAs and DCAPs (if they are offered). In these situations, employers may wish to emphasize spending deadlines and the consequences of missed deadlines (including forfeitures) to help employees make informed election decisions.
In addition to informal communications, Sky Crafts should also be aware of ERISA’s formal notice requirements. If Sky Crafts amends its ERISA plan document and SPD, ERISA requires it to notify participants by distributing a Summary of Material Modification (SMM). An SMM generally must be distributed within 210 days after the end of the plan year in which the amendment is effective, but Sky Crafts should distribute it ahead of time if possible. In some cases, an amendment may not be enforceable against a particular employee if the employee has not received notice of the change. For that reason, distributing SMMs as soon as practicable is preferred.
For more information on ERISA’s notice requirements, please ask your broker or consultant for a copy of the NFP publication ERISA Compliance Considerations for Health and Welfare Benefit Plans.
Reaching Your Final Destination: ERISA Form 5500 and PCOR Obligations
Sky Crafts will have two plan years ending in the same calendar year and will need to file two sets of Forms 5500: one for the plan year ending October 31, and a second for the short plan year ending December 31. Unless Sky Crafts requests an extension, the filings would be due May 31 and July 31, respectively (i.e., seven months following the end of each plan year). Sky Crafts must also distribute a corresponding Summary Annual Report to participants within two months after each Form 5500 filing.
Likewise, Sky Crafts should pay PCOR fees to the IRS for two plan years in one filing after the transition: fees for the plan years ending October 31 and December 31. Sponsors of self-insured group health plans are required to remit PCOR fees to the IRS by July 31 for all plan years that ended in the prior calendar year.
For more information on these requirements, please ask your broker or consultant for a copy of the NFP publications Form 5500: A Guide for Employers, Summary Annual Report: A Guide for Employers, and PCOR Fees: A Guide for Employers.
Final Thoughts
Changing plan years requires advance planning and communication. By being proactive and setting expectations, an employer can ensure a smooth landing for its employees as it transitions to a new plan year.