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New proposed Cafeteria Regulations
On August 6, 2007, the Internal Revenue Service issued
new proposed cafeteria plan regulations under section
125 of the Internal Revenue Code. The proposed regulations
replace existing regulations dating back to 1984. The proposed regulations incorporate and restate prior
proposed regulations and add much needed clarification. The
new proposed regulations are expected to be effective for a plan’s
year starting on or after January 1, 2009, but can be relied upon
immediately.
Background
A cafeteria plan allows an employer to offer certain benefits to
employees on a pre-tax basis. To qualify, an employee agrees to
reduce compensation in exchange for benefits chosen prior to the
start of the plan year. The proposed regulations reaffirm that a
cafeteria plan must offer employees a choice between at least one
permitted taxable benefit (typically cash) and at least one qualified
nontaxable benefit.
Nonqualified Benefits A plan offering any nonqualified benefit is not a cafeteria plan.
A cafeteria plan can not offer any of the following benefits: - scholarships
- employer-provided meals and lodging
- educational assistance
- fringe benefits
- contributions to Archer Medical Savings Accounts
- group-term life insurance for spouse, child or dependent
- elective deferrals to tax-sheltered annuity plans or
- long-term care insurance
A plan offering only elections among nontaxable benefits or a
plan offering only elections among taxable benefits is not a cafeteria
plan. In order to keep the qualified benefits from being taxable
to employees and ensure the plan is valid, employers will need to
comply with the new proposed regulations. Below are some cafeteria plan requirements that reflect several of
the general changes of the new proposed cafeteria regulations.
Written Plan A cafeteria plan must be in writing and be operated in accordance
with the written plan terms and must: - specifically describe all benefits
- set forth eligibility rules, enrollment and election procedures
- provide that all elections are irrevocable
- state how employer contributions may be made
- state the maximum amount of elective contributions
- state the plan year
- specify that only employees may participate
- specify that the cafeteria plan year be for a 12-month period
If the cafeteria plan provides a flexible spending arrangement
(FSA), it must also include provisions complying with the uniform
coverage rule and the “use-it-or-lose-it” rule.
Qualified Benefits A cafeteria plan can only offer qualified benefits. Qualified benefits
are generally benefits attributable to employer contributions
that are not currently taxable to the employee by reason of an
express provision of the Code and do not defer compensation.
Qualified benefits include health and insurance benefits, such as
medical, dental, vision, life insurance and disability plan. The new
proposed regulations also recognize adoption assistance plans,
certain deferred compensation benefits and health savings accounts
(HSAs) as qualified benefits.
Elections A cafeteria plan must require irrevocable elections annually,
which must be made before the first day of the coverage period.
Certain mid-year elections are permitted if they are included in
the written cafeteria plan document. There is also a special rule
that applies if the plan offers HSA contributions through salary
reduction. Automatic elections are also permitted. Elections,
revocations or changes in elections can be made electronically.
Flexible Spending Arrangements (FSAs) FSAs are designed to reimburse employees for incurred expenses
of certain qualified benefits up to a designated amount. All benefits
and contributions must be used by the end of the plan year
(“use-or-lose-it” rule) or they must be forfeited. The required
period of coverage for all FSAs is twelve months. The period of
coverage and the plan year need not be the same. Non-elective
employer contributions (or so-called “flex-credits”) can be used
at the employee’s election for qualified benefits.The new proposed regulations recognizes three types of FSAs: - dependent care assistance
- adoption assistance
- medical care reimbursements
Experience Gains (Forfeitures) Unused amounts are now referred as “experience gains.” The
new rules retain the forfeiture allocation rules of prior guidance
under which the employer sponsoring the cafeteria plan may: - retain forfeitures
- use forfeitures to defray expenses of administering the plan
- allocate forfeitures among participating employees
Substantiation of Claims A cafeteria plan may only pay or reimburse an expense that is: - properly substantiated
- incurred on or after enrolled in a particular qualified benefit
- incurred while covered under the particular qualified benefit
Nondiscrimination The cafeteria plan must not discriminate in favor of highly compensated
individuals with respect to eligibility, contributions and
benefits. Also, several key terms are now defined, including dependent,
highly compensated individual or participant, officer,
five percent shareholder, key employee and compensation. Testing
under the new rules must be performed as of the last day of
the plan year. The proposed regulations establish two safe harbors,
under which a plan is deemed to be nondiscriminatory.
Conclusion Cafeteria Plans will soon be more formal, particularly in terms of
documentation, substantiation and nondiscrimination. Specific
information regarding the proposed regulations can be found
www.ustreas.gov/press/releases/reports/section125.pdf.
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