The rules of Notice 2005-42 are illustrated with the following examples taken directly from the Notice:

Example 1
Employer with a cafeteria plan year ending on December 31, 2005, amended the plan document before the end of the plan year to permit a grace period which allows all participants to apply unused benefits or contributions remaining at the end of the plan year to qualified benefits incurred during the grace period immediately following that plan year. The grace period adopted by the employer ends on the fifteenth day of the third calendar month after the end of the plan year (March 15, 2006 for the plan year ending December 31, 2005). Employee X timely elected salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2005, X has $200 remaining unused in his health FSA. X timely elected salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2006. During the grace period from January 1 through March 15, 2006, X incurs$300 of unreimbursed medical expenses (as defined in § 213(d)). The unused $200 from the plan year ending December 31, 2005 is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period. Therefore, as of march 16, 2006, X has no unused benefits or contributions remaining for the plan year ending December 31, 2005. The remaining $100 of medical expenses incurred between January 1 and March 15, 2006 is paid or reimbursed from X's health FSA for the plan year ending December 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2006.

Example 2
Same facts as Example (1), except that X incurs $150 of § 213(d) medical expenses during the grace period (January 1 through March 15, 2006). As of March 16, 2006, X has $50 of unused benefits or contributions remaining for the plan year ending December 31, 2005. The unused $50 cannot be cashed-out, converted to any other taxable or nontaxable benefit, or used in any other plan year (including the plan year ending December 31, 2006). The unused $50 is subject to the "use-it-or-lose-it" rule and is forfeited. As of March 16, 2006, X has the entire $1,500 elected in the health FSA for the plan year ending December 31, 2006.

S & A's Take
As this does not have an immediate impact to current plans, we believe a wait-and-see position should be taken. We can implement this amendment (required if company wishes to offer benefits of Notice 2005-42) by year-end and announce the new policy to the plan participants. It is not, by and of itself, a change in election event.

There is recent US Senate activity, similar to a bill that passed through Congress last year, which would make this Treasury announcement moot. Ms. Olympia Snowe of Maine has introduced SB 723, which in effect will eliminate the "use-it-or-lose-it" aspect of FSAs by allowing a rollover of up to $500 from plan year to plan year. Senator Snowe is supported by a key senator and Chairman of the Finance Committee, Mr. Charles Grassely of Iowa.

Harry Becker, IRS Health & Welfare Chief, has recently indicated that more needs to be done to bring FSAs into line with the current administration's position on consumer-driven healthcare. Mr. Becker's indication suggests a major IRS change in position.

We are watching these developments closely and urge patience at this time.