This is the first of several reports on the five new sets of Internal Revenue Service (IRS) regulations affecting cafeteria plans. This article will navigate through a portion of the first set of new regulations that detail the rules on qualified and nonqualified benefits within a cafeteria plan.
Clarifies and amplifies the general management of a cafeteria plan. It contains written plan document requirements, along with a discussion of grace period, run-out period, and after-tax employee contributions. It also includes communication on prohibited taxable benefits, COBRA premiums, prevention of deferred compensation, nonqualified benefits and employer contributions to a cafeteria plan.
Each regulation is divided into sections with the different sets of regulations containing a differing number of sections. Regulation 1.125-1 contains a whopping 18 distinct sections. This article will only reflect on the first six segments.
1. Basic ground rules and definitions are contained in the first section. The plan must be in a written format and offer at least one "permitted" taxable benefit and at least one "qualified" nontaxable benefit, and must not provide for the deferral of compensation.
Taxable benefits can include cash, which is defined as salary reduction, payments for paid time off and severance pay. A distribution from a retirement plan is not considered cash, but other cash options would include property, taxable employer contributions and benefits purchased with after-tax employee contributions.
Qualified benefits include benefits not currently taxable to the employee and encompass – group-term life insurance on the life of the employee for coverage that does not exceed $50,000; an accident and health plan (including a health flexible spending account (FSA); premiums for COBRA continuation coverage; accidental death and dismemberment policies; long-term or short-term disability; dependent care assistance; adoption assistance; deferrals to a 401(k) plan; certain plans maintained by an educational organization; and contributions to a Health Savings Account (HSA).
The definition of a dependent as it applies to cafeteria plans generally means a dependent as defined in Internal Revenue Code (IRC) section 152 (a tax dependent). And the definition of a premium-only-plan is a cafeteria plan that offers only an election between cash and payment of the employee share of the employer-provided accident and health insurance coverage.
2. This section of general rules surrounding cafeteria plans reiterates the basic premise that IRC section 125 is the exclusive means by which an employer can offer employees an election between taxable and nontaxable benefits without the election resulting in the benefits being included in taxable income. If the plan does not meet all the rules set out for cafeteria plans, the amount of the taxable and nontaxable benefits selected, will be all taxable to the employee.
However, benefits that fail discrimination tests under the various IRC sections do not fail to be qualified benefits. The discriminatory amounts are simply included in gross income, not the entire amount of the benefit(s). Discrimination testing is detailed in the 1.125-7 regulations.
The employer who provides a written notice may automatically enroll employees into benefits when a new employee is hired or during the annual election process. The notice must include the salary reduction amounts for employee-only coverage and family coverage, procedures for certifying whether the employee has other health coverage, elections for family coverage, information on the time by which a certification or election must be made and the period of time for which a certification or election will be effective. The notice for a current employee must also include a description of the employee’s existing coverage.
In order for a plan to be a cafeteria plan, the qualified benefits and permitted taxable benefits offered through the plan must not defer compensation. Deferred compensation includes providing retirement health benefits for current employees beyond the current plan year or offering group-term life insurance with a permanent benefit.
3. As stated in the old regulations, the cafeteria plan must be a written document. It must be adopted and effective on or before the first day of the cafeteria plan year, and the terms must apply uniformly to all participants. The written plan document must contain:
 | A specific description of each benefit. |
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| The plan's rules governing participation. |
| Procedures for elections into the plan. |
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| The manner of contributions – whether they are salary redirection or employer flex credits. |
| The maximum amount of contributions expressed as a maximum dollar amount or a maximum percentage of compensation. |
| The plan year dates. |
| Whether the plan offers paid time off and the required ordering rules. |
| The additional requirements for FSAs. |
| Any grace period for incurring and receiving reimbursement for claims incurred after the end of any specific plan year. |
| Whether the plan allows for distributions from a health FSA to an employee’s Health Savings Account (HSA). |
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| Whether the plan allows for deferrals into a 401(k) plan. |
| A written plan for the health FSA as well as the dependent care and adoption assistance plans, whether those written plans are separate documents or included in the cafeteria plan. |
Amendments to the plan must also be in writing and be effective for periods after the later of the adoption date or the effective date of the amendment. This means no retroactivity of contributions, claims or reimbursements are allowed through the plan.
In addition – if no written plan document exits, or if the written plan fails to satisfy any of the requirements, then the plan is not a cafeteria plan. Also, if the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with IRC section 125 and the accompanying regulations, the plan is not a cafeteria plan. That means that all benefits are taxable to the participants.
The laundry list of operational failures include:
| Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, an amendment, or a participant’s enrollment date. |
| Offering benefits other than permitted taxable or qualified nontaxable benefits. |
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| Operating to defer compensation. |
| Failing to comply with the uniform coverage rule. This means that the health FSA must pay all eligible claims up to the annual election amount even if the reimbursement is in excess of contributions received to date for the individual participant. |
| Failing to comply with the use-it-or-lose-it rule. In other words, a participant must forfeit any unused funds at the end of the applicable plan year or grace period. |
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| Allowing employees to change elections except as outlined in the change of election regulation 1.125-4. |
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| Failing to comply with the substantiation requirements summarized later in regulation 1.125-1. |
| Paying or reimbursing ineligible expenses. |
| Returning forfeited amounts to participants other than expressly permitted by regulation 1.125-5. |
| Failing to comply with the grace period rules outlined in regulation 1.125-1. |
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| Failing to comply with the qualified HSA distribution rules in regulation 1.125-5. |
4. The plan year for a cafeteria plan must be 12 consecutive months unless a short plan year is instituted. However, plan years may be changed for a valid business purpose. This allows for changing a plan year or short plan years after the cafeteria plan has been established. It does not prohibit the running of two short plan years one after another. However, upon audit, the changing of plan years and consecutive short plan years would be critically examined.
5. Employers may allow a grace period in which participant expenses incurred in a new plan year may use leftover funds from their previous plan year.
6. Since their inception, cafeteria plans have been written with a provision for a run-out period. A run-out period is a span of time after the end of the cafeteria plan year in which participants may turn in claims that were incurred in the previous plan year. Previous plan year funds are used to pay these run-out claims. The new regulations codify this procedure with a caveat that the run-out period be provided on a uniform and consistent basis with respect to all participants.
You can see from this listing that the amount of information imparted by the IRS is immense. Let’s face it – the IRS had 20 years of pent-up rules they have communicated all at once. So, we'll be tackling the remainder of the 1.125-1 regulations in future articles and then move on to the others as the year rolls by.
As a reminder – the regulations are due to become effective on January 1, 2009. Plan documents must be amended or restated for mandatory changes before that time. However, some or all of the new regulations may be utilized now in the administration of a cafeteria plan. That means plan sponsors can immediately institute pieces of the new legislation that they like and then wait until the last minute to establish the changes that are complicated or difficult to administer.
