The Internal Revenue Service (“IRS”) issued the long awaited new proposed regulations governing the operation of cafeteria plans under Section 125 of the Internal Revenue Code (“Section 125”) on August 6, 2007. These new proposed regulations (“proposed regulations”) reflect numerous changes in the tax laws that have occurred over the past two decades, incorporate prior IRS guidance (both formal and informal) pertaining to the operation of cafeteria plans, and introduce new rules and concepts. These include new guidance on the application of the non-discrimination rules and new definitions of qualified and nonqualified benefits. The regulations also stress the importance of maintaining a written plan document and complying with the requirements of Section 125.
The proposed regulations will generally become effective for plan years beginning on or after January 1, 2009. However, employers may rely on these proposed regulations until they are finalized. There are some exceptions to the delayed effective date, such as the change in the calculation of taxable income for employee group-term life insurance (discussed below), which was effective August 6, 2007.
This article is intended to provide an overview of the significant requirements and changes set forth in the proposed regulations.
Section 125 Cafeteria Plan Basic Requirements
GeneralThe proposed regulations clarify that a Section 125 cafeteria plan (“Section 125 plan”) is the exclusive means by which an employer can offer employees the choice between taxable and nontaxable benefits. Consistent with prior IRS rulings, if an employer offers employees a choice between taxable and nontaxable benefits without having a written Section 125 plan in place, all employees will be taxed on income equal to the full amount of cash they could have elected to receive. The proposed regulations retain the fundamental requirement that, in order for the plan to qualify under Section 125, the employee must be permitted to choose among at least one qualified (i.e., nontaxable) benefit and one nonqualified benefit (i.e., taxable cash). Any purported cafeteria plan that does not offer a choice between at least one qualified and one nonqualified benefit will not be considered a cafeteria plan under Section 125. If a plan only offers nontaxable benefits it is not a Section 125 plan, and employees will be taxed on the full value of the taxable benefit.
Written Plan Requirement
A Section 125 plan must be formally documented in a written plan document. The proposed regulations specify that all plan provisions and amendments must be in writing. If there is no written plan document, or if a plan fails to operate in accordance with the written plan document, or if a plan fails to operate in compliance with Section 125, then the plan will not be considered a Section 125 plan and employees will be taxed on the full value of the taxable benefit.
The proposed regulations specifically require the written plan document to include:
- A description of all benefits offered under the plan
- Rules for eligibility to participate, including a statement that all participants must be employees
- Procedures for making elections
- A statement that all elections are irrevocable (unless an optional change in status rule applies)
- A statement of how employer contributions may be made under the plan
- The maximum amount of elective contributions available to any employee in the plan
- The plan year (which, with very limited exceptions, must be a consecutive 12-month period)
- Provisions for run-out and grace periods (if adopted)
- Special requirements relating to paid time off
- Specific requirements for FSAs including health care, dependent care, and adoption assistance FSAs
- Provisions for distributions and contributions to HSAs( if offered under the plan).
The Section 125 plan must be formally adopted and effective on or before the first day of the plan year to which it relates. In addition, the proposed regulations make clear that amendments may not be retroactive. In other words, a written amendment must be formally adopted prior to a new plan provision becoming effective and such plan provision is only effective for periods after the later of the specified effective date or the date the amendment is adopted.
12-Consecutive-Month Plan Year Requirement
The plan year must be specified in writing in the plan document. Generally, the plan year must be a period of 12 consecutive months. The proposed regulations permit a short plan year only in limited circumstances when there is a “valid business purpose.” For example, the proposed regulations indicate that an employer’s change in insurance carriers may serve as a valid business purpose.
Grace Periods and Run-Out Periods
Pursuant to IRS Notice 2005–42 (as amplified by IRS Notice 2005–86), a Section 125 plan may offer a grace period following the end of the plan year. The proposed regulations incorporate the prior guidance and contain some additional provisions. The grace period must immediately follow the end of the plan year and may not exceed 2 months and 15 days. During the grace period, participants may continue to incur expenses for qualified benefits that may be treated as if they were incurred during the prior plan year. The grace period must be made available to all individuals who are participants in the plan as of the last day of the plan year, including participants who elect COBRA continuation coverage that may be retroactively effective on the last day of the plan year. All grace periods must be specified in the written plan document.
The proposed regulations provide employers with some options relating to grace periods. For example, the grace period need not be available for all benefits, i.e., an employer could chose to provide a grace period for the health FSA but not for the dependent care FSA. In addition, an employer may limit the amount of unused benefits or contributions available during the grace period. An employer may also treat expenses for qualified benefits incurred during the grace period either as expenses incurred during the previous plan year or during the current plan year. Finally, an employer also has the option to shorten the grace period to less than 2 months and 15 days.
As is common practice, the proposed regulations permit a Section 125 plan to have run-out provisions, as long as they are applied uniformly and consistently to all plan participants.
Eligibility to Participate in a Section 125 Plan
In order to participate in a Section 125 plan, the individual must be an employee. Under the proposed regulations, an employee includes:
- a common law employee;
- a leased employee as described in Internal Revenue Code (“Code”) Section 414(n); and
- a full-time life insurance sales person.
Former employees (i.e., an employee who was laid off or has retired) may participate in a Section 125 plan. However, the plan must not be established predominantly for former employees. The proposed regulations indicate that an eligible spouse or dependent may receive benefits under a Section 125 plan (e.g., an employee may pay for their spouse’s or dependent child’s health plan coverage on a pretax basis under the Section 125 plan); however, the spouse or dependent child is not considered a participant in the Section 125 plan.
Self-employed individuals are not considered employees under Section 125. The proposed regulations state that sole proprietors, partners in a partnership, directors of corporations (who serve solely on the board of directors and not as employees), and 2% shareholders of an S corporation are not employees for purposes for Section 125. Thus, these individuals may not participate in a Section 125 plan.
While only employees (including former employees) may participate in a Section 125 plan, the proposed regulations specifically allow a Section 125 plan to permit employees to elect health coverage for a former spouse, domestic partner or other person who is not a Code section 152 tax dependent, but the coverage must be paid for with aftertax money. Note that, in addition, any employer contributions toward the cost of health coverage for a former spouse or other person who is not a Code section 152 tax dependent (e.g., a domestic partner) must be treated as imputed income to the employee.
Permissible Benefits Under a Section 125 Plan
A Section 125 plan must offer participants an election among permitted taxable benefits (i.e., cash) and qualified nontaxable benefits. A plan that does not offer a choice between cash and at least one qualified benefit is not a Section 125 plan. Below is a summary of the benefits that may be offered under a Section 125 plan pursuant to the proposed regulations.
Permitted Taxable Benefits
The proposed regulations clarify that, taxable benefits are limited to cash and certain other taxable benefits treated as cash for the purposes of Section 125. “Cash” includes cash compensation, payment for annual leave, sick leave or other paid time off, and severance pay. “Other taxable benefits” treated as cash for the purposes of Section 125 include property, benefits attributable to employer contributions that are currently taxable to the employee upon receipt by the employee and certain benefits purchased with after-tax employee contributions.
Qualified Nontaxable Benefits
Qualified benefits are generally those that are not includible in the gross income of the employee pursuant to a specific section of the Code. The proposed regulations state that, for purposes of a Section 125 plan, only the following are qualified nontaxable benefits:
- Group-term life insurance on the life of an employee (up to a maximum of $50,000)
- Employer-provided accident and heath plans (including health FSAs)
- Premiums for COBRA continuation coverage
- Accidental death and dismemberment insurance policies
- Long-term or short-term disability coverage
- Dependent care assistance programs
- Adoption assistance programs
- Contributions to 401(k) plans
- Contributions to certain plans maintained by educational organizations
- Contributions to HSAs
Additionally, the proposed regulations specify that the following are nonqualified benefits: scholarships, employer provided meals and lodging, educational assistance, fringe benefits (as defined under Code section 132), long-term care insurance, contributions to Archer Medical Savings Accounts, groupterm life insurance on the life of an employee’s spouse, child or other dependent (e.g., a domestic partner), and elective deferrals to Section 403(b) plans.
If a plan offers a nonqualified benefit (even if it is paid for with after-tax money), then the plan will not be treated as a Section 125 plan with respect to any benefits.
No Deferred Compensation
Generally, a Section 125 plan may not offer benefits that defer compensation by carrying benefits over to a later plan year. In addition, salary deferrals from one plan year may not be used to purchase benefits in another plan year. The proposed regulations identify certain benefits and plan administration practices that are not considered to defer compensation including:
- salary reduction contributions taken in the last month of a plan year that are used to pay accident and health insurance premiums for the first month of the following plan year;
- certain two-year lock-in vision and dental policies;
- certain advance payments for orthodontia;
- reimbursement of Code section 213(d) medical expenses for durable medical equipment that may have a useful life of more than one year;
- salary reduction contributions for long-term disability policies that pay benefits over more than one plan year;
- reasonable premium rebates or policy dividends; and
- allocation of experience gains among participants.
The proposed regulations also identify benefits in accident and health insurance policies that, for purposes of a Section 125 plan, do not defer compensation even though they may apply for periods beyond one plan year. The following do not defer compensation: reasonable lifetime limits on benefits, level premiums, premium waiver during disability, guaranteed renewability, coverage for specified accidental injury or specific diseases, and payment of a fixed daily amount in the event of hospitalization.
Individual Accident and Health Policies
The proposed regulations permit a Section 125 plan to pay or reimburse substantiated individual accident and health insurance premiums. Although this is a favorable change, the proposed regulations do not specifically address state mandated health care laws, like those currently in place in Massachusetts, Connecticut, Missouri and Rhode Island that require an employer to provide a Section 125 plan. Presumably, contributions to state mandated health plans will be permissible under a Section 125 plan but, unfortunately, the proposed regulations do not provide clear guidance on these state mandates.
Note that, as under prior guidance, a Section 125 plan may not reimburse the cost of premiums for a health FSA.
Purchase of Paid Time Off Under a Section 125 Plan
Under the proposed regulations, the term “paid time off” refers to vacation days and other types of paid time off, such as sick days or personal days. An employer may offer paid time off as a permitted taxable benefit under a Section 125 plan. However, as before, paid time off may not be carried over from one year to the next. The ordering rules that were in effect under prior guidance continue to apply; an employee must first use nonelective paid time off and then use elective paid time off (i.e., additional time purchased under the Section 125 plan). If an employee has unused elective paid time off, the employee must be cashed out for such time before the end of the plan year (i.e., before December 31st for a calendar year plan) or it will be forfeited. No grace period will apply to paid time off.
Immediate Change in the Tax Treatment of Group-Term Life Insurance
The proposed regulations contain significant changes to the tax treatment of group-term life insurance. These changes were effective immediately upon the issuance of the proposed regulations (i.e., August 6, 2007). Prior to the issuance of the proposed regulations, with respect to employee group-term life insurance in excess of $50,000, an employer was required to include in the employee’s gross income the greater of the Table I cost of the excess coverage or the amount of the employee’s salary reduction and any employer flex-credits. Under the proposed regulations, an employer is required to include in the employee’s gross income the Table I cost of group-term life insurance in excess of $50,000 (less any after-tax contributions paid by the employee). All salary reductions and employer flexcredits are now excludable from the employee’s gross income. As a result, effective immediately, employers must modify their tax treatment of employees who receive group-term life insurance in excess of $50,000 through a Section 125 plan.
Making, Revoking and Changing Elections in Section 125 Plans
The proposed regulations contain a few key changes in the area of Section 125 plan elections.
First, the Section 125 plan may provide for automatic elections for new employees (often referred to as “default elections”) or current employees (often referred to as “evergreen elections”) who fail to make an election during the initial or annual enrollment period. Note that the labor laws of some states (e.g., California) may prohibit this practice of automatic or default elections. This type of automatic enrollment process is not recommended for FSAs (or HSAs) because amounts elected tend to vary from year to year, particularly with respect to health FSAs.
The proposed regulations also permit a Section 125 plan to allow new employees to make Section 125 plan elections within 30 days after hire and have the elections be effective as of the date of hire. This is a change from the current rules that generally do not permit retroactive elections. Employers who have extended the new hire election period to 60 or 90 days may want to amend their plan back to provide that new employees have only 30 days to make elections.
If HSA contributions are made through salary reduction, the Section 125 plan must provide that employees may prospectively elect, revoke or change the amount of their election for HSA contributions at any time during the plan year with respect to salary not currently available at the time of the election.
The proposed regulations also specify that Section 125 plan elections may be made electronically in accordance with the requirements of Treasury Regulations Section 1.401(a)–(21).
Specific Requirements for Flexible Spending Arrangements
Many of the requirements of the previous proposed regulations have been retained with respect to FSAs. For example, the period of coverage is still generally required to be 12 consecutive months Changes of note are discussed below.
The proposed regulations retain the uniform coverage rule for health FSAs. This rule requires the maximum amount of reimbursement to be available at all times during the period of coverage. The use-itor- lose-it rule also remains the same. The proposed regulations permit, but don’t require, a Section 125 plan to reimburse advance payments for orthodontia in the year in which the payments are made. A Section 125 plan may also reimburse advance payments for durable medical equipment even though it may have a useful life of more than one year.
Dependent Care FSAs
The proposed regulations give employers the option to permit employees to spend down their remaining balance in a dependent care FSA for any dependent care expenses incurred after termination of employment with the employer who sponsors the Section 125 plan. Any expenses incurred after termination of employment must meet all of the usual requirements for reimbursement under Code section 129. The expenses must also be incurred before the end of the plan year (and any applicable grace period).
Adoption assistance is recognized under the proposed regulations as a qualified benefit that is excludible from gross income if elected. Generally, the rules that apply to reimbursement for dependent care assistance programs are also applicable to adoption assistance programs.
The proposed regulations provide that the employer who sponsors the Section 125 plan may retain forfeitures, use them to pay plan administration expenses, or allocate them among employees contributing to the plan through salary reductions on a reasonable and uniform basis. The Section 125 plan document should specify how forfeitures will be used.
Substantiation of Expenses
The proposed regulations specify that only expenses for qualified benefits incurred after the Section 125 plan’s effective date and during the participant’s period of coverage are reimbursable. They also state that medical and dependent care expenses are incurred when the services are provided, not when the employee is formally billed, charged for, or pays for the care.
Moreover, they clarify that all claims must be substantiated by a third party independent of the employee and the employee’s spouse and dependents before the expense may be paid or reimbursed. The third party must provide information describing the service or product, the date of service or sale and the amount. Substantiating only a percentage of claims, or claims above a certain dollar amount, is insufficient.
Use of Debit Cards for FSAs
The proposed regulations restate guidance issued in IRS Notice 2007–2 regarding the use of health FSA and HRA debit cards at stores with Drug Stores and Pharmacies merchant category codes. After December 31, 2008, debit cards may not be used at stores with the merchant category code for Drug Stores and Pharmacies unless the store either participates in the inventory approval system or 90 percent of the store’s gross receipts qualify as medical care expenses.
The proposed regulations also clarify that employers that use the inventory information approval system to substantiate claims are responsible for ensuring that the system complies with the substantiation requirements of Sections 1.105–2, 1.125–1 and 1.125–6 of the Code, the medical expense criteria of Code section 213(d), and the recordkeeping requirements of Code section 6001. The inventory information approval system for substantiating health FSA claims is required for merchants that are not health care providers, such as grocery stores, and certain stores with the merchant category code for Drug Stores and Pharmacies as described above. From a practical standpoint, we are not sure how employers will monitor a store’s compliance with these provisions.
The proposed regulations also provide guidance on the cafeteria plan nondiscrimination rules which are intended to prevent plans from discriminating in favor of highly compensated individuals. Plans must pass the following tests:
- an eligibility test;
- a contributions and benefits test; and
- a key employee concentration test.
Although a plan will not be disqualified if it fails any of these tests, the benefits received by highly compensated individuals will be taxable to them if the plan is found to be discriminatory.
While the proposed regulations for the most part restate prior guidance, they also provide additional guidance on the application of the eligibility test and contributions and benefits test and introduce a new safe harbor for premium-only-plans. They also modify or clarify definitions of certain key terms, such as “highly compensated individual or participant,” “officer”, “5% shareholder,” “key employee” and “compensation.”
Changes to the Eligibility Test
The eligibility test determines whether the plan benefits enough non-highly compensated individuals. The proposed regulations modify the eligibility test by adding a benefits component. This new component requires that benefits and employer flex credits be made equally available to highly compensated participants and to non-highly compensated participants. With this new rule, plans that provide for immediate entry and 100% employee eligibility may no longer automatically pass the eligibility test, particularly if the plan provides different benefit or contribution structures for different classes of participants. Previously, plans were not required to look at benefits or contributions in conducting the eligibility test – these items were only important for purposes of passing the contributions and benefits test and the key employee concentration test.
The proposed regulations also provide a safe harbor for passing the “reasonable classification test” which borrows concepts from the qualified plan world: the nondiscriminatory classification test under Code section 410(b). This safe harbor may be helpful to plans that are not available to all employees of an employer. A plan will pass the reasonable classification test if:
- the plan benefits a group of employees who qualify under a reasonable classification established by the employer as defined in Treasury Regulations section 1.410(b)–4(b). These reasonable classifications include nature of compensation (e.g., hourly or salaried), job categories, geographic location, and similar bona fide business criteria (e.g., full-time or part-time); and
- the group of employees included in the classification satisfies the safe harbor percentage test or the unsafe harbor percentage component of the “facts and circumstances” test as provided in the pension table in Treasury Regulations section 1.410(b)–4(c). Generally, a plan will pass the test if more than 50% of non-highly compensated individuals are eligible.
The facts and circumstances test is only available if:
- the plan’s ratio percentage is less than the safe harbor percentage but greater than or equal to the unsafe harbor percentage specified in the pension table in Treasury Regulations section 1.410(b)–4(c)(iv); and
- the classification is nondiscriminatory based on all the relevant facts and circumstances as determined by the IRS (see Treasury Regulations section 1.410(b)–4(c)(3)(ii) for the facts and circumstances which are relevant in making this determination).
Changes to the Contributions and Benefits Test
The “contributions and benefits test” consists of a “benefits” component which determines whether benefits and contributions are equally available to employees and a “utilization” component which determines whether highly compensated individuals are disproportionately utilizing plan benefits. The proposed regulations clarify the utilization component by requiring plans to show that all eligible employees have a uniform opportunity to make elections and that the actual elections of qualified benefits and the actual elections of qualified benefits with employer contributions are not disproportionately made by highly compensated participants. To demonstrate this, the regulations require plans to show that neither the aggregate qualified benefits nor the aggregate contributions elected and utilized by highly compensated participants exceed the aggregate benefits and contributions elected and utilized by nonhighly compensated participants. Plans must measure these aggregate amounts as a percentage of the respective group’s compensation.
New Safe Harbor for Premium-Only-Plans
The proposed regulations provide a new safe harbor for premium-only plans (plans which only offer an election between cash — e.g., salary — and payment of the employee share of the employer-provided accident and health insurance premium). A plan will be deemed to satisfy the nondiscrimination rules of Code section 125(c) for a plan year if the plan satisfies the eligibility test’s new safe harbor percentage test for the year. Such a plan will not be required to run the contributions and benefits test or the key employee concentration test.
Permitted Disaggregation for Testing Purposes
The proposed regulations provide some measure of relief to plans that cannot pass testing when the plan population is tested as a whole. The new rules would permit such a plan to be disaggregated into two plans — one plan that benefits employees who have completed up to three years of employment and another plan that benefits employees who have completed at least three years of employment. Each of these component “plans” must be tested separately for both the “eligibility test” and the “contributions and benefits test”.
Additional Clarifications of Note
The proposed regulations include a number of clarifications. The rules clarify that that nondiscrimination testing must be performed as of the last day of the plan year and must take into account all nonexcludable employees (including former employees) who were employees on any day during the plan year. This means that a plan may not rely on a “snap-shot” approach to conduct the eligibility test and must continue to track all employees who are terminated during the course of the year. In addition, a plan will be treated as discriminatory if it makes repeated changes to its testing procedures or plan provisions for the principal purpose of passing testing. Lastly, the proposed regulations clarify that if an employer makes contributions to employees’ HSAs through a cafeteria plan, those contributions will be subject to the nondiscrimination rules under Section 125 and not to the HSA comparability rules under Code section 4980G.
While the provisions in the proposed regulations are generally effective for plan years beginning on or after January 1, 2009, employers may rely upon these changes now. Employers should begin reviewing their plan documents to ensure that all of the necessary provisions are included and that the plan is operating in accordance with the terms of the written plan document. Remember that, going forward, any amendments to the Section 125 plan must be formally adopted before they may become effective.
If you have any questions concerning the proposed regulations or require assistance with amending your Section 125 plan, please contact Julie Burbank, Tiffany Santos, Barbara Pletcher, Liz Loh, or Michelle Schuller.