Compliance Bulletin — Proposed Cafeteria Plan Regulations from the IRS

November 2008

A few months ago, the Internal Revenue Service (IRS) issued new proposed cafeteria plan regulations. The regulations are intended to clarify the rules on the administration of cafeteria plans by replacing, updating, and expanding on existing guidance.

This bulletin is to serve as a reminder and provides a summary of some of the key changes that will apply to plan years beginning on or after January 1, 2009.

The proposed regulations affect the following Sections of the IRS code:

            Section 1.125-1         Cafeteria Plans; General Rules
            Section 1.125-2         Cafeteria Plans; Elections
            Section 1.125-5         Flexible Spending Arrangements
            Section 1.125-6         Substantiation of Expenses for All Cafeteria Plans
            Section 1.125-7         Cafeteria Plan Nondiscrimination Rules

These regulations do not change the rules on mid-year election changes, which are found in section 1.125-4.

The General Rules – Section 1.125-1

  • The revised regulations clarify and stress a Section 125 plan is the exclusive means by which employers can give employees the choice between taxable and non-taxable benefits.
  • If the employer’s cafeteria plan does not follow the rules and fails to operate according to the terms of its written plan document, it is not deemed a cafeteria plan, and the tax advantages are lost.
  • A section 125 plan must be in writing in a separate written plan document adopted before the effective date of the plan. The rules contain a list of required elements, which are listed below:
    • Description of the benefits available through the plan, including the period of coverage in which the benefits are provided
    • Plan rules governing participation, including specific language that all participants must be employees
    • Procedures around employee elections, including when elections are made, period in which elections are effective, and the requirement that elections are irrevocable except to the extent the change in status rules apply
    • Manner in which employer contributions are made (i.e., employee salary reduction, employer contributions, or both)
    • Maximum amount of employer contributions available to any employee through the plan
    • The plan year of the cafeteria plan
    • Plans offering paid time off must include language on the required ordering rule and cash-out or forfeiture
    • Plans providing flexible spending arrangements (FSAs) must include provisions for complying with the uniform coverage rule and the “use it or lose it” rule
    • If the plan provides a grace period, it must include required language applicable to the grace period
    • If the plan permits distributions from the FSA to a Health Savings Account (HSA), proper plan amendments and language must be contained in the written plan
  • The plan need not be self-contained; in other words, the cafeteria plan may incorporate by reference other separate written plans that describe benefits offered through the cafeteria plan. Amendments to the plan must also be in writing and on a prospective basis only.
  • The plan must operate for a period of 12 consecutive months. The plan year may be changed, or a short plan year may be adopted, “only for a valid business purpose.”
  • All participants in the plan must be employees (including laid off and retired employees). “Employee” includes common law employees, leased employees, and full-time life insurance agents. “Employee” does not include, however, sole proprietors, partners, or corporate directors.
  • If the employer provides group term life coverage in excess of $50,000, the proposed regulations outline the impact of that coverage on the employee’s gross income. The new regulations define that the cost of group term life insurance offered through a cafeteria plan in excess of $50,000 is calculated based on the Table I cost of excess coverage minus any after-tax contribution (Section 1.79-3(d)(2), Table I). The entire amount of pre-tax salary reduction or employer flex credits is excludable from the employee’s gross income. Currently, the rules state that the cost of coverage is the employee’s actual cost under the cafeteria plan or greater of the Table I cost, whichever one is greater.

Elections in Cafeteria Plans – Section 1.125-2

  • The proposed regulations explain that annual elections are generally irrevocable, unless the employer has incorporated into its written plan document the mid-year election change rules contained in section 1.125-4. If HSA contributions are made through the cafeteria plan, employees may prospectively elect, revoke, or change their elections at any time with respect to salary that has not become currently available at the time of the election.
  • The rules also explain that a cafeteria plan may include an automatic election for new or current employees. In addition, new employees may make an election within 30 days after the date of hire, even if benefits elected relate back to the date of hire. In such a case, salary reduction amounts used to pay for the election must be from compensation not yet currently available on the date of the election.
  • Employees, but not spouses and dependents, may make electronic elections

Flexible Spending Arrangements – Section 1.125-5

The proposed regulations restate and expand on earlier regulations on FSAs.

  • The regulations now define in more detail that although FSAs must have a one-year period of coverage, employers may have a different period of coverage for each benefit offered through the FSA (such as a different period for the health FSA, the dependent care FSA, etc.). These periods may also be different from the plan year.
  • The regulations also address HSAs, which did not exist when the earlier regulations were issued. The regulations explain that a limited-purpose FSA or post-deductible health FSA is not a high deductible health plan and therefore is not incompatible with an HSA.
  • The regulations also discuss the treatment of experience gains (which are sometimes referred to as forfeitures under the use-it-or-lose-it rules). Experience gains may be: kept by the employer; used to reduce required salary reduction amounts in the immediate year following; returned to employees on a reasonable and uniform basis; or used to defray administrative expenses of the plan.

Substantiation of Expenses for All Cafeteria Plans – Section 1.125-6

  • All expenses incurred must be substantiated before they can be paid. “Substantiating only a percentage of claims, or substantiating only claims above a certain dollar amount, fails to comply” with the rules. Substantiation must come from an independent third party, not the employee or dependent.
  • Debit cards are allowed. However, the regulations outline how claims must be substantiated when debit cards are used. Debit cards may not be used after December 31, 2008 at pharmacies or drug stores that do not have the inventory information approval system requirement.

Cafeteria Plan Nondiscrimination Rules – Section 1.125-7

The new regulations provide new guidance on nondiscrimination testing for cafeteria plans. They define several terms, and also provide guidance on the eligibility test, contributions and benefits test, and provide an objective test to determine when the actual election of benefits is discriminatory. The regulations also include a safe harbor for plans offering premium-only benefits.

Employer Action Plan

Employers should:

  1. Ensure you have cafeteria plan documents in place and updated
  2. Ensure that you are performing nondiscrimination testing on your cafeteria plans annually
  3. Implement the new Life Insurance calculations of the cost of coverage in excess of $50,000
  4. Review your health flexible spending account arrangement if you offer an HSA plan

This is only a summary. This summary does not constitute legal or tax advice. Employers should consult their own legal and tax counsel concerning whether and how these issues and this guidance should be implemented, as well as whether there are other legal issues that need to be addressed as part of the ongoing administration of their employee benefit plans.