Deadline Quickly Approaching to Redraft Section 125 Cafeteria Plans
In August of 2007, the Internal Revenue Service (IRS) made a significant move in withdrawing over two decades’ worth of temporary and proposed cafeteria plan regulations and, in their place, issuing new proposed regulations which greatly impact current cafeteria plan designs and administration.
The proposed regulations, which were published in the Federal Register on August 6, 2007, clarify numerous provisions of the previous regulations, describe how a plan will lose its qualified status, expand the nondiscrimination requirements and incorporate newer changes in the law.
At the forefront of this guidance, the IRS strongly reiterates the written plan requirement. If an employer offers its employees a choice between taxable and nontaxable benefits without a written document being in place, all participating employees are treated as if they had chosen the taxable benefit.
The IRS actions are significant and represent that the IRS will likely begin paying more attention to cafeteria plan compliance and nondiscrimination testing. Employers therefore must ensure that their plan documents and operations are properly prepared for strict scrutiny by the IRS.
Highlights of regulations
Any employer offering a choice between taxable and nontaxable benefits will need to pay close attention to these new proposed regulations and the resulting commentary. The proposed regulations contain numerous anticipated clarifications, as well as new rules which may require amendments to cafeteria plans.
While by no means exhaustive, here is a summary of highlights from the updated IRS guidance.
Qualified and nonqualified benefits in cafeteria plans Written document and qualified status
Significantly, if a cafeteria plan is not in writing and is not operated in accordance with its terms, the plan will lose its qualified status, resulting in all employees being taxed as if they had chosen the taxable benefits available to them. Therefore, now is a very important time to make sure the plan’s terms are in accordance with your operations. Inconsistency will cause plan failure. The proposed regulations include ten specific items that must be included in the plan documentation, including describing underlying benefits, coverage periods and the maximum monetary amounts running through the plan. They also set forth a number of instances which automatically disqualify a plan and result in taxation to all participating employees, such as offering nonqualified benefits, deferring compensation or failing to comply with the substantiation rules.
Twelve-month plan year
The proposed rules include the requirement that a plan year must be 12 months and provide that short plan years are only allowed for valid business purposes, as described in the regulations.
Group-Term life insurance
The proposed regulations immediately modified the Notice 89-110 rules on how group-term life insurance in excess of $50,000 is taxed to employees, specifically providing that the employee is taxed on the Table I cost of the excess coverage alone (minus any after-tax contributions by the employee) with no consideration being made for any salary reduction or employer flex-credits which are excludible from the employee’s gross income.
Individual and COBRA premiums
Under the new proposed regulations, a cafeteria plan (but not a health flexible spending account [FSA]) may pay or reimburse substantiated individual accident and health insurance premiums. However, until further guidance is issued, we caution employers regarding this provision as it could run afoul of HIPAA’s nondiscrimination rules as well as have ERISA implications. Additionally, cafeteria plans may provide for the payment of COBRA premiums for an employee.
Practices found not to defer compensation
Benefits and plan administration practices that defer compensation are not allowed to be funded through a cafeteria plan. Whether some benefits fell into this category was questionable, and the new proposed regulations provide needed clarification, stating that certain two-year lock-in vision and dental policies, advance payments for orthodontia, and salary reduction contributions in the last month of a plan year used to pay accident and health insurance premiums for the first month of the following plan year do not defer compensation and therefore can properly be included in a cafeteria plan.
Elections in cafeteria plans New employee retroactive election
Notwithstanding certain exceptions, the proposed regulations allow cafeteria plans to provide retroactive coverage to the date of hire if new employees make their election within 30 days after their hire date, as long as the salary reduction is from compensation not yet available on the date of the election.
Flexible spending arrangements Adoption assistance
In addition to the typical FSAs offered through cafeteria plans (dependent care assistance and medical care reimbursements), the new regulations incorporate rules allowing for adoption assistance under §137 to also be provided through FSA arrangements.
Amounts forfeited by employees at the end of the plan year (or upon termination of participation) are referred to as experience gains. The proposed regulations clarify that these experience gains may be retained by the employer (although ERISA plans are prohibited from retaining participant forfeiture under the exclusive benefit rule issues), can be used to defray expenses associated with administering the plan or can be allocated among employees on a reasonable and uniform basis as described in the regulations.
Qualified HSA distributions
The IRS has also incorporated the prior guidance on qualified health savings account (HSA) distributions. In order for employees to take advantage of this FSA rollover, the plan must be amended and numerous requirements must be followed. If you intend on allowing FSA rollovers to an HSA, be sure to contact your plan attorney for guidance.
Substantiation of expenses for all cafeteria plans
If claims, including expenses charged on debit cards, are not properly substantiated in accordance with the rules, all amounts paid under the cafeteria plan will be included in gross income. Self-substantiation of claims by employees is not proper; substantiation must be made by an independent third party. Employers should review their cafeteria plan’s current payment procedures closely.
If reimbursements are made without third party verification (i.e., with receipts or other acceptable methods through the use of debit cards), the plan’s qualified status will fail.
Significantly, the IRS has provided much needed additional guidance on the cafeteria plan nondiscrimination rules, including definitions of key terms; guidance on the eligibility test and the contributions and benefits tests, including an objective test to determine when the election of benefits is discriminatory; descriptions of employees allowed to be excluded from testing; and a safe harbor nondiscrimination test for premium-only plans.
It is incredibly important to review your cafeteria plan under these new rules to ensure compliance upon issuance of the final regulations.
If you have or are considering implementing a cafeteria plan, you should have your benefit structure reviewed by your attorney to ensure that your plan is compliant with the cafeteria plan rules.
IRS Circular 230 Disclosure
Unless expressly stated otherwise, this document is not intended or written to function as a covered opinion under Department of Treasury regulations. Any federal tax advice within this document is not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties that may be imposed, or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein.
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Elizabeth Latchana is an attorney with Fraser, Trebilcock, Davis & Dunlap, PC and specializes in employee benefits law.