IRS Issues Proposed Cafeteria Plan Regulations
WHAT IS IT?: – On August 3, 2007 the IRS issued proposed regulations on Cafeteria Plans. With one exception regarding life insurance, the regulations are effective January 1, 2009. Comments on the proposed regulations are due November 5th with hearings to be held on November 15th.
WHY IS IT IMPORTANT? – The proposed regulations withdraw previously issued proposed guidance (some over 20 years old!), Notices, Revenue Rulings and consolidate them into one document incorporating changes in tax law (e.g., definition of dependent, HSAs) as well as add new rules. The new proposed regulations do not affect previously issued regulations regarding FMLA (1.125-3) and permitted election changes (1.125-4).
The new proposed regulations are now the only guidance regarding cafeteria plans and may be relied upon until final regulations are issued.
HIGHLIGHTS OF THE PROPOSED REGULATIONS:
- Effective immediately, the proposed regulations change the manner in which the taxable cost of group term life insurance is calculated. In addition, group term life insurance is a qualified benefit regardless of the amount of insurance provided that it is not combined with any permanent benefits.
- The cafeteria plan can allow an employee to pay COBRA premium to another employer.
- The cafeteria plan must be in writing and must operate in accordance with its terms
- A cafeteria plan is permitted to allow employees to elect accident and health coverage for an individual who is not the spouse or dependent of the employee as a taxable benefit.
- An optional election for new employees that provides 30 days after date of hire for an employee to make an election between cash and qualified benefits.
- A new optional rule permits an employer to reimburse a terminated employee’s qualified dependent care expenses incurred after termination through a dependent care FSA if all section 129 requirements are otherwise satisfied.
- A much needed clarification is the definition of a highly compensated individual which know refers to the 414(q) definition used by 401(k) plans. Further, compensation is defined as 415(c)(3) compensation. These two Code sections should be familiar to those of you who work with 401(k) plans.
OVERVIEW OF THE PROPOSED REGULATIONS
A word of warning – the proposed regulations are 124 pages long and provide numerous examples, some useful, some not! We will provide an overview of some of the key provisions. People familiar with retirement plan rules will begin to notice some similarities in the proposed cafeteria plan rules.
Cafeteria plan general rules
A cafeteria plan is a separate written plan that
- complies with the requirements of section 125 and the regulations,
- is maintained by an employer for employees and
- is operated in compliance with the requirements of section 125 and the regulations.
Section 125 is the exclusive means by which an employer can offer employees a choice between taxable and nontaxable benefits without the choice itself resulting in inclusion in gross income by employees. Therefore, except for an election made through a cafeteria plan that satisfies section 125 or another specific Code Section, any opportunity to elect among taxable and nontaxable benefits results in inclusion of the taxable benefit regardless of what benefit is elected and when the election is made.
Unless a plan satisfies the requirements of section 125 and the regulations, the plan is not a cafeteria plan.
All participants in a cafeteria plan must be employees. Employees include
- common law employees,
- leased employees and
- full time life insurance salesmen; former employees (but the plan may not be maintained predominantly for former employees).
A participant’s spouse or dependents may receive benefits through a cafeteria plan but cannot participate in the plan. Self-employed individuals are not treated as employees for section 125.
Cafeteria plan must offer employees an election among only permitted taxable benefits (including cash) and qualified non taxable benefits. It must offer at least one permitted taxable benefit and at least one qualified benefit. A cafeteria plan must not defer compensation except as specifically permitted in the proposed regulations. The permitted taxable benefits and qualified non-taxable benefits are summarized in the following table.
| Permitted taxable benefits | Qualified non-taxable benefits |
|
any benefit attributable to employer contributions to the extent the benefits is not currently taxable to the employee by reason of an express provision of the Internal Revenue code including:
|
A qualified benefit may be offered through a cafeteria plan even if the qualified benefit fails its applicable nondiscrimination test.
Nonqualified benefits
A cafeteria plan must not offer any of the following
- Scholarship (§117)
- Employer provided meals and lodging (§117)
- Educational assistance (§127)
- Fringe benefits (§132)
- Long term care insurance (an HSA funded through a cafeteria plan may be used to pay premiums for long-term care)
- Contributions to Archer Medical Savings Account
- Group term life insurance for an employee’s spouse, child or dependent
- Elective deferrals to 403(b) plans
- Carryover of unused benefits in a health FSA
Bottom line: If a plan offers an employee a choice between taxable benefits and non-taxable qualified benefits and does not meet the requirements of the proposed 125 regulations in both form and operation – the benefit with the greatest value will be included in the gross income of the employee.
The Written Plan Requirement
The proposed regulations require that a cafeteria plan be in writing and that the cafeteria plan must be operated in accordance with the written plan terms. The plan must be adopted and effective before the first day of the play year to which it relates.
The written plan must contain:
- A specific description of each of the benefits available through the plan including the periods during which the benefits are provided.
- The plan’s rules governing participation and specifically requiring that all participants in the plan be employees.
- The procedures governing employees’ elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective and providing that elections are irrevocable except to the extent that the optional change in status rule are include in the cafeteria plan.
- The manner in which employer contributions may be made under the plan.
- The maximum amount of employer contributions available to any employee through the plan by stating the maximum amount of elective contributions available to any employee through the plan, expressed as a maximum dollar amount or a maximum percentage of compensation or the method for determining the maximum dollar amount and for contributions to a section 401k plan the maximum amount of elective contributions.
- The plan year of the cafeteria plan; the plan year must be 12 consecutive months and can only be changed for valid business reasons.
- If the plan offers paid time off, the required ordering rule for use of nonelective and elective paid time off.
- If the plan includes FSAs, the plan’s provision complying with any additional requirements for those FSAs e.g., uniform coverage rule and use it or lose it rules.
- If the plan includes a grace period, the plan’s provisions must comply with the provisions in the regulations.
- If the plan includes distributions from health FSA to an employee’s HSA, the plan provisions complying with the provisions in regulations.
Additional requirements:
A written plan is required for self insured medical reimbursement plans, dependent care assistance programs and adoption assistance programs. Any of the programs offered through a cafeteria plan that satisfies the written requirement in the proposed regulations also satisfies the requirements of the specific sections or they can be provided through a separate written plan not a part of the cafeteria plan.
If the cafeteria plan offers HSA contributions, the plan must specifically describe the HSA contribution benefit; allow a participant to prospectively change his or her salary reduction for HSA contributions on a monthly basis, and allow a participant who becomes ineligible to make HSA contributions to prospectively revoke his or salary reduction election for HSA contributions.
In describing the benefits available through the cafeteria plan, the written cafeteria plan need not be self contained.
Any amendment to the cafeteria plan must be in writing.
The plan may contain:
- A grace period of up to the fifteenth day of the third month immediately following the end of each plan year. A grace period is available for all qualified benefits except that the grace period does not apply to paid time off and elective contributions under a 401(k) plan. The grace period must state that unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expense incurred with respect to the same qualified benefit.
- A run out period after the end of the plan year during which a participant can submit a claim for reimbursement for a qualified benefit incurred during the plan year or grace period.
- A requirement that employee must pay the employee’s share of any qualified benefit through salary reduction and not with after tax employee contributions.
- An optional election for new employees that provides 30 days after date of hire for an employee to make an election between cash and qualified benefits. If this provision is elected, the plan must provide that any employee, who terminates and is rehired within 30 days after termination or returns following an unpaid leave of absence of less than 30 days, is not a new employee eligible for this election. The election will become effective as of the date of hire however salary reduction amounts must be from compensation not yet currently available at the time of election. For example, if an employee is hired 9/10/2007, the employee has until 10/10/2007 to make an election for coverage which will be effective as of 9/10/2007 (assuming the plan allows for immediate coverage) but salary reductions can not begin until after the election is made.
- At the employer’s option, a cafeteria plan is permitted to provide that only those employees who participate in one or more specific employer provided accident and health plans may participate in a health FSA.
Bottom line: Plan sponsors have some decisions to make regarding the optional provisions. In any event, if there is no written plan or plan fails to satisfy any of the requirements, the plan is not a cafeteria plan and any employee’s election between taxable and nontaxable benefits results in gross income to the employee. Likewise, if the plan fails to operate in accordance with its terms, the plan is not a cafeteria plan and any employee’s election between taxable and nontaxable benefits results in gross income to the employee
Employer provided accident and health plans
Coverage under an employer provided accident and health plan that satisfies the requirements of 105(b) may be provided as a qualified benefit through a cafeteria plan and is excludible from the employees’ gross income. The nondiscrimination requirements under 105(h) apply to self-insured medical reimbursement arrangements including health FSAs.
In order for an accident and health plan to be a qualified benefit that is excludible from gross income if elected through a cafeteria plan, the cafeteria plan and the accident and health plan must satisfy their respective nondiscrimination requirements.
A cafeteria plan (but not a health FSA) may pay or reimburse substantiated individual accident and health insurance premiums. In addition, a cafeteria plan may provide for payment of COBRA premiums for an employee.
For purposes of employer provided health plans and medical reimbursement plans, the definition of dependent is the definition provided by the Working Families Tax Relief Act of 2004.
Cafeteria plan elections
A plan is not a cafeteria plan unless the plan provides in writing that employees are permitted to make elections among the permitted taxable benefits and qualified benefits offered through the cafeteria plan for the plan year. Benefit elections must be made before the earlier of the date when taxable benefits are currently available or the first day of the plan year (or other coverage period).
Cash or another taxable benefit is currently available to the employee if it has been paid to the employee or if the employee is able currently to receive the cash or other taxable benefit at the employee’s discretion (the constructive receipt rule).
All elections are irrevocable unless the plan incorporates the change in status rules (which most plans do). Only an employee of the employer sponsoring the cafeteria plan may make, revoke or change elections in the employer’s plan. The employee’s spouse, dependent or any other individual other than the employee, may not make revoke or change elections under the plan.
Elections can be made electronically. The IRS safe harbor regarding electronic media applies to elections, revocations and changes in elections under §125.
For new employees or current employees who fail to timely elect between permitted taxable benefits and qualified benefits, a cafeteria plan is permitted, but is not required, to provide default elections for one or more qualified benefits (e.g., an election made in the prior year is continued for the succeeding plan year unless otherwise elected by the employee).
A cafeteria plan offering HSA contributions through salary reduction may permit employees to make prospective salary reduction elections or change or revoke salary reduction elections for HSA contributions at any time during the plan year, effective before the salary becomes currently available. The written plan document must also contain specific provisions (see Written plan requirement above).
A cafeteria plan may provide new employees 30 days after their hire date to make elections between cash and qualified benefits. The election is effective as of the employee’s hire date but the salary reduction amounts used to pay for the election must be from compensation not yet currently available on the date of the election. The written plan document must also contain specific language (see Written plan requirement above).
Bottom line: Nothing really new with respect to elections except for the optional election available to new employees. Remember this provision is not required; it is the employer’s choice.
Group Term Life Insurance
In addition to offering group term life insurance up to $50,000, a cafeteria plan may now offer coverage in excess of that amount.
The proposed regulations change the calculation of the amount includible in income as follows:
| Current Rules | Proposed (effective immediately) |
| Notice 89-110 provides that an employee include in gross income the greater of the Table I cost of group-term life insurance coverage exceeding $50,000 or the employee’s salary reduction and employer flex-credits for excess group-term life insurance | The new proposed regulations provide that the employee include in gross income the Table I cost of excess coverage (minus after tax contributions by the employee for group-term life insurance coverage) and that the entire amount of salary reduction and employer flex credits for group term life insurance coverage on the life of the employee is excludible form the employee’s gross income. |
Flexible Spending Arrangements
There are three types of flexible spending arrangements (FSAs) – dependent care, adoption assistance and health FSA.
The uniform coverage rules require that the maximum amount of reimbursement from a health FSA must be available at all time during the period of coverage. Uniform coverage rule doesn’t apply to dependent care or adoption assistance. The period of coverage is 12 months with exception for short plan years
At the employer’s option, a cafeteria plan is permitted to provide that only those employees who participate in one or more specific employer provided accident and health plans may participate in a health FSA.
In addition:
- The use it or lose it requirement is retained; however, the regulations refer to it as “use or lose”.
- A health FSA may not reimburse premiums for accident and health insurance or long term care insurance.
- Section 105(h) nondiscrimination rules apply to health FSAs
- All medical expenses must be substantiated before expenses are reimbursed
- Experience gains (unused amounts) – retain 1989 rules regarding retaining forfeitures, pay administrative expenses, allocate forfeitures.
- FSAs for dependent care assistance and adoption assistance must follow the substantiation procedures applicable to health FSAs.
- After an employee incurs an expense for a qualified benefit during the coverage period, the expense must first be substantiated before the expense may be paid or reimbursed
- The employer is responsible for ensuring that the inventory information approval system complies with the new regulations and recordkeeping requirement.
A new optional rule permits an employer to reimburse a terminated employee’s qualified dependent care expenses incurred after termination through a dependent care FSA if all section 129 requirements are otherwise satisfied
Bottom line: The regulations incorporate previously issued guidance and offer new options in the area of dependent care reimbursement. A word of caution is that the regulations reiterate that it is the employer’s responsibility for ensuring that the inventory approval system used with debit cards is in compliance with the regulations.
Nondiscrimination testing requirements
Discriminatory benefits provided to highly compensated participants/individuals and key employees are included in these employees’s gross income. The new proposed regulations provide additional guidance on the cafeteria plan nondiscrimination rules, including definitions of key terms, guidance on the eligibility test and the contributions and benefits tests, descriptions of employees allowed to be excluded from testing and a safe harbor nondiscrimination test for premium only plans.
The new proposed regulations define several key terms including highly compensated individual or participant, officer, five percent shareholder, key employee and compensation. A much needed clarification is the definition of a highly compensated individual which know refers to the 414(q) definition used by 401(k) plans. Further, compensation is defined as 415(c)(3) compensation. These two Code sections should be familiar to those of you who work with 401(k) plans.
The new proposed regulations also provide guidance on the nondiscrimination testing by providing a safe harbor for premium only plans as well as providing guidance on the current nondiscrimination requirements.
A cafeteria plan must not discriminate as to:
- Eligibility and
- Contributions and benefits.
Nondiscrimination as to eligibility
A cafeteria plan must not discriminate in favor of highly compensated individuals as to eligibility to participate for that plan year. A cafeteria plan will satisfy the eligibility requirements if the plan satisfies the reasonable classification test currently available to retirement plans. The employees included in the classification must satisfy either the safe or unsafe harbor percentage of the facts and circumstances test in IRC regulations 1.410(b)-4(c).
In addition, any employee who has completed three years of employment and satisfies any conditions for participation in the cafeteria plan that are not related to completion of a requisite length of employment must be permitted to elect to participate in the cafeteria plan no later than the first day of the first plan year beginning after the date the employee completed three years of employment.
To grossly oversimplify the test, a ratio must be calculated for the highly compensated individuals and the nonhighly compensated individuals. The ratios are then compared to a chart in the regulations; if the calculated ratios “fit into” the chart, then the plan satisfies the nondiscrimination as to eligibility requirements. In calculating the ratios, the employer has some choices as to who to include in the testing.
The examples provided in the regulations are simplistic without reference to the percentages or the chart. The examples are also somewhat confusing to this reader and require clarification.
Nondiscrimination as to contributions and benefits
A cafeteria plan must not discriminate in favor of highly compensated participants as to contributions and benefits. To satisfy nondiscrimination as to contributions and benefits a plan must satisfy both a benefit availability requirement and a benefit utilization requirement.
A plan must give each similarly situated participant a uniform opportunity to elect qualified benefits and highly compensated participants must not actually disproportionately elect qualified benefits.
To demonstrate that qualified benefits are not disproportionately elected, percentages must be calculated for both the highly compensated and non highly compensated participants. The numerator is the qualified benefits elected and the denominator is the participant’s compensation. An aggregate percentage is calculated for each group (HCE and non HCE) and compared. If the HCE percentage exceeds the non HCE percentage, then qualified benefits are disproportionately provided to HCEs. (for those of you familiar with 401(k), it’s beginning to sound like ADP/ACP testing).
A plan must also give each similarly situated participant a uniform election with respect to employer contributions and the actual election with respect to employer contributions f or qualified benefits through the plan must not be disproportionate by highly compensated participants.
Bottom line: The proposed regulations clarified some issues, borrow some things from the nondiscrimination rules for retirement plans but need more illustrative examples using real life scenarios to better explain the application of the rules.
Key employee concentration test
There is also the key employee concentration test which requires that for any plan year, statutory nontaxable benefits provide to key employees must not exceed 25% of the aggregate of statutory nontaxable benefits provided for all employees through the cafeteria plan. If the plan fails this test, an amount equaling the maximum taxable benefits that could have been elected for the plan year, is includible in the key employee’s income.
Safe Harbors
The proposed regulations provide nondiscrimination safe harbors for premium only plans and cafeteria plans providing health benefits
Premium only plans
A premium only plan is deemed to satisfy the nondiscrimination rules for a plan year if for that plan year, the plan satisfies the safe harbor percentage test for eligibility.
Cafeteria plans providing health benefits
A cafeteria plan that provides health benefits is not treated as discriminatory as to benefits and contributions if contributions on behalf of each participant include an amount which equals 100% of the cost of the health benefit coverage under the plan of the majority of the highly compensated participants similarly situated or equals or exceeds 75% of the cost of the health benefit coverage of the participant (similarly situated) having the highest cost health benefit coverage under the plan.
Health benefits for purposes of this rule are limited to major medical coverage and exclude dental coverage and health FSAs.
WHAT SHOULD YOU DO NOW?
- Revise your method for calculating the cost of Group term life insurance
- Review your cafeteria plan document for compliance with the new regulations both in form and operation.
- Begin to think about the optional provisions permitted by the regulations
- If so inclined, read the regulations and provide comments to the government by November 5th
- Keep your eyes open for any clarifications regarding the nondiscrimination testing
Note: This material is for the sole purpose of providing general information and does not under any circumstances constitute legal advice and should not be used as a substitute for legal advice. You should seek the advice of counsel when applying the requirements to your plans. For more information on this ErisaALERT, contact us by phone at 610-524-5351 and ask for Mary Andersen or 973-994-7539 and ask for Theresa Borzelli.
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