Charitable FSAs: A Proposal to Combine Healthcare and Charitable Giving Tax Provisions

This Article considers two unrelated tax provisions-health care Flexible Spending Accounts (FSAs) and the charitable deduction. FSAs permit eligible taxpayers to set income aside tax-free to use for medical expenses. However, these accounts have a "use-it-or-lose-it" feature that discourages participation and creates incentives for unnecessary spending at year-end. The charitable deduction is available only to those who itemize their deductions, thus negating the incentive to give for the 65% of taxpayers who take the standard deduction. Prior attempts to fix these provisions separately-allowing taxpayers to roll over unused FSA amounts to the next year and moving some or all of the charitable deduction "above the line"-have failed. I propose combining the two provisions by allowing taxpayers to donate unused FSA amounts to charity. Doing so would lower a key impediment to participation in FSAs while giving a functional above-the-line deduction (and relief from payroll taxes) to those who donate through this mechanism. Not only would this reform increase the efficacy of both provisions, but it should also avoid many of the pitfalls of prior stand-alone reform efforts. I. INTRODUCTION The ongoing national debate over health care reform has revealed a deep divide over how best to promote social welfare. Regardless of this debate's outcome, one thing seems certain: tax incentives will remain an important tool in advancing health care policy. The insurance mandate and associated penalty have received the lion's share of media attention, yet a number of other provisions play an important role in encouraging individuals to acquire health insurance, save for their medical needs, and monitor their expenditures. In this article, I focus on health care flexible spending accounts (FSAs),1 which permit taxpayers to set aside money tax-free for medical needs. Largely ignored by legal academics,2 FSAs loom large in die minds of those eligible to participate. Before each tax year begins, taxpayers must estimate their unreimbursed medical expenses for the upcoming year.3 If they choose to participate, they must make an irrevocable election to set aside money to cover such expenses on a tax-free basis. FSAs are subject to a "use-it-or-lose-it" rule. Thus, if taxpayers overestimate tJieir needs, they must either race to spend unused amounts on items they would not otherwise have purchased or forfeit those amounts to their employer. As discussed more fully below, although most taxpayers consider FSAs to be a form of tax-favored savings account, the Internal Revenue Service (IRS) considers them to be a form of health insurance. Many of the rules that make FSAs so ineffective, such as the use-it-or-lose-it rule, can be explained in large part by this fact. No data exists regarding how much time and energy taxpayers spend trying to assess tJieir anticipated medical expenses, how many taxpayers underfund their accounts, or how many spend unused money at year- end to avoid forfeiture. However, of the approximately 40% of U.S. employees eligible for such accounts, only 22% - about 8% of all U.S. employees - participate in FSAs.4 The charitable deduction is also viewed by many as being deeply flawed. Some criticize the deduction because it provides an "upsidedown" subsidy, where high-income taxpayers receive a greater benefit than low-income taxpayers.5 Others focus on the fact that some taxpayers are allowed to deduct the full market value of donated property while others are limited to deducting basis.6 However, the issue that has received the most attention has been the placement of the deduction "below the line," so that it is not available to the approximately 65% of taxpayers who take the standard deduction.7 To date, stand-alone efforts to fix the perceived problems with these provisions - by allowing taxpayers to roll unused amounts over to the next year and by moving some or all of the charitable deduction "above the line" - have failed. …