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Proposed Cafeteria Plan Regulations

In August 2007, the IRS issued "new proposed" Section 125 regulations that pertain to cafeteria plans that make significant changes to the way cafeteria plans are established and administered.

To whom does the proposed regulations apply?
Any employer who maintains, or is considering maintaining, a Section 125 plan.

What do the proposed regulations do?
The proposed regulations make a number of clarifications to previously issued guidance, withdraw certain existing proposed and temporary rules and establish several new requirements that cafeteria plans must meet.

The most significant changes that affect cafeteria plans are as follows:

• Written Plan Document Requirement. Cafeteria plans now must be in the form of a written plan document and are required to include certain information, such as a description of the benefits offered through the plan, rules regarding participation, elections and contributions, HSA contributions (if applicable) and any special requirements that relate to health FSA and dependent care FSA benefits (i.e. use-it – or lose-it rule, uniform reimbursement rule).
  
  In addition, cafeteria plan documents are not permitted to be established with a retroactive effective date. As a general rule any plan document must be effective as of the first day of the plan year in which it relates and any amendment can only be effective for periods after the later of the effective date or the adoption date.
  
  Failure to meet this written plan document requirement will disqualify the cafeteria plan as a Section 125 plan and result in adverse tax consequences to both the participants and employer.
• Nondiscrimination Testing. Cafeteria plans have always been prohibited from discriminating in favor of highly compensated employees; however there has not been clear guidance as to how to apply the various nondiscrimination tests until now. The proposed regulations define several key terms, including a definition of highly compensated individual or participant (which corresponds with highly compensated employee definition under 414(p) for purposes of a qualified pension plans), five percent shareholder, officer, key employee and compensation. In addition, the proposed regulations apply a new objective test to determine when the election of benefits is discriminatory.
• Group-Term Life Insurance. The proposed regulations favorably change the way that participants will be taxed on employer sponsored group-term life insurance in excess of $50,000. The amount taxed to a participant is now based on the Table I (contained in Section 79) cost of coverage in excess of $50,000, minus all after-tax contributions by the employee. In addition, the proposed regulations specify that any amounts contributed by the participant through a cafeteria plan and/or any employer flex credits are excludible from the employees gross income. Prior to these proposed regulations a participant was taxed on the greater of (1) the Table 1 cost of coverage exceeding $50,000, or (2) the total amount of employee contributions to a cafeteria plan and/or employer flex credits used to purchase this coverage.
• New Employee Enrollment. A cafeteria plan may permit new employees the option of electing to participate in the plan within 30 days from their start date with coverage being effective retroactive to their date of hire. This proposed rule does not apply to someone that terminates and is rehired within 30 days of termination or someone that returns from an unpaid leave of absence and is rehired or returns in less than 30 days.
• Plan Years. A cafeteria plan year must consist of 12 consecutive months and generally cannot include a short plan year unless the reason for the short plan year is for a "valid business purpose." The proposed regulations include the following circumstances under which a short plan year will be considered for a "valid business purpose:"
  • Initial plan year of the plan.
  • Change in coverage period of the health insurance plan. For example, if an employer provides coverage through an insured arrangement with Insurer A and such arrangement runs from 01/01/2008 – 12/31/08, but the employer discontinues coverage as of 03/01/08 and establishes new coverage with Insurer B as of 03/01/08. This would be considered a valid business purpose under the proposed regulations and the employer would be permitted to have a short cafeteria plan year for 2008 consisting of 01/01/2008 – 02/28/08 and establish a new plan year from 03/01/08 – 02/28/09.
• Reimbursement of Premiums. A cafeteria plan, but not a health FSA, is permitted to pay or reimburse individual accident and health insurance premiums, provided the plan sponsor receives proof that the coverage is in force and that certain other substantiation requirements are met.
• COBRA Premiums. The proposed regulations clarify that COBRA premiums may be paid for through a cafeteria plan, but not a health FSA. For example, if an employee shifts from full-time to part-time and becomes ineligible for their employer provided health insurance and elects COBRA, the employer could permit this employee to pay his or her COBRA premiums on a pre-tax basis through the cafeteria plan.
• Dependent Care FSA. Plan sponsors are not allowed to adopt an optional spend down provision that would permit a participant to use any unused monies remaining in his or her dependent care FSA for eligible expenses incurred after his or her participation in the plan ends (i.e. after termination of employment).
• Orthodontia Expenses. As a general rule, expenses from a health FSA cannot be reimbursed until the expenses are incurred. The proposed regulations make an exception to this rule and allow plan sponsors to permit reimbursement of eligible orthodontia expenses before the services are actually performed.

When do the proposed regulations go into effect?
The proposed regulations are generally effective for plan years beginning on or after January 1, 2009.  We are waiting for final regulations to be issued by the IRS.

How does this impact plan sponsors?
Plan Sponsors need to take steps to fully understand the many requirements of the proposed regulations. All plan sponsors are going to have to review their written cafeteria plan document (if any) and their administrative practices to ensure that both meet the requirements under the proposed regulations.

With regard to the plan document, plan sponsors should review their cafeteria plan documents to determine whether plan amendments or restatements are needed to comply with mandatory changes such as the new written plan requirement, non discrimination testing and any of the optional provisions of the proposed regulations that the plan sponsor wishes to implement (i.e. advance payment of orthodontia expenses). If the plan sponsor has a cafeteria plan that is merely an administrative policy and no written plan document exists, establishment of a written policy is required.