IRS Reproposes Comprehensive Cafeteria Plan Regs

(Published September 6, 2007)

Regulations governing the general framework of cafeteria plans were proposed in 1984 but never finalized. In the ensuing 23 years, the IRS has issued numerous guidance documents on topics ranging from changing elections due to changes in status, to reimbursing expenses via debit cards. Rather than maintain this piecemeal approach, the IRS has opted to repropose comprehensive regulations. The regs encompass all previous guidance and include new rules, too, especially regarding health savings accounts (HSAs). Biggest improvement: The regs more clearly state the requirements cafeteria plans must meet, how plans can fail, and the tax consequences to employees when plans do fail. The regs are proposed to be effective with plan years beginning after January 1, 2009, but you may rely on them before that date.

Plan Documents 

Cafeteria plans must still be written. The regs detail what must go into a plan document. The written-plan requirement is significantly expanded from the previous proposed regs, so you should ensure that your plan is compliant.

Under the new rules, plan documents must state the plan year; describe the benefits offered; specify how employer contributions are made (e.g., through pre-tax deductions or non-elective employer contributions); state the maximum amount of employees' pre-tax contributions; detail the rules for eligibility; and explain how employees make elections, including a provision requiring that their elections be irrevocable for the plan year (unless the plan includes the optional change-in-status rules). If the plan includes a flexible spending account (FSA), the plan document must include provisions complying with the uniform coverage rule and the use-it-or-lose-it rule.

Plan Benefits 

Cafeteria plans must still restrict employees' choices to taxable benefits and qualified, non-taxable benefits. The regs incorporate previous guidance on health, dependent care, and adoption assistance FSAs. The regs don't authorize cafeteria plans to offer new benefits, and include previous guidance on grace periods, debit cards, and negative-option plans.

Taxable benefits include cash; payment for annual leave, sick leave, or other paid time off; severance pay; property; and certain after-tax contributions. Qualified, non-taxable benefits include group-term life insurance; employer-provided accident and health benefits, including health FSAs; accidental death and dismemberment policies; dependent care assistance; adoption assistance; contributions into a 401(k) plan; contributions into HSAs; and long-term and short-term disability coverage.

The regs also cite the benefits that can't be offered through cafeteria plans, even if employees pay for them with after-tax dollars: scholarships; employer-provided meals and lodging and educational assistance; certain fringe benefits allowed under tax code Section 132; and long-term care insurance and long-term care services.

Old benefits, new choices. The regs allow cafeteria plans, but not health FSAs, to pay or reimburse substantiated individual (not group) accident and health insurance premiums. So employees can buy individual policies and pay premiums with pre-tax dollars.

The regs allow COBRA benefits to be paid for on a pre-tax or after-tax basis. Also, cafeteria plans may allow employees to pay for health benefits with after-tax dollars; this is important for employees who want to cover domestic partners or former spouses.

A new optional rule permits employers to reimburse a terminated employee's qualified dependent care expenses incurred after termination through a dependent care FSA, provided all the requirements of Section 129 are met.

Special rules for HSAs. Generally, employees' cafeteria plan elections must be irrevocable for the plan year, unless the plan allows changes in elections due to changes in status. The one big exception is HSA elections. Cafeteria plans that offer HSA contributions must allow participants to prospectively change their pre-tax deductions on a monthly or a more frequent basis, and allow participants who become ineligible for HSAs to prospectively revoke their pre-tax elections.

Plan Failures 

There are two ways cafeteria plans can fail — they can fail the written-plan requirement or they can fail operationally. Either way, otherwise non-taxable benefits, such as health benefits, become fully taxable to employees. Operational failures are many and include the following:

• paying or reimbursing expenses for qualified benefits employees incur before the later of the date the cafeteria plan is adopted or the effective date of the cafeteria plan;

• offering benefits other than permitted taxable benefits and qualified, non-taxable benefits;

• deferring compensation;

• FSAs failing to comply with the uniform coverage rule or the use-it-or-lose-it rule;

• allowing employees to revoke elections and make new elections mid-plan-year;

• not obtaining substantiation from employees prior to reimbursing them;

• paying or reimbursing expenses that FSAs can't cover;

• not complying with the grace period rules, if included in the cafeteria plan;

• improperly disposing of plan forfeitures; or

• not complying with the HSA distribution rules.

Non-Discrimination Rules 

The regs define key terms, including highly-compensated individuals or participants, officers, 5% shareholders, key employees, and compensation to be consistent with the 401(k) rules. The regs also incorporate some of the 401(k) rules regarding eligibility. Unlike the prior proposed regs, these regs provide an objective test to determine when the actual election of benefits is discriminatory. Under this objective test, plans must give each similarly-situated participant a uniform opportunity to elect qualified benefits, and highly-compensated participants must not actually disproportionately elect qualified benefits.

The proposed regs contain copious examples of what is and isn't permitted. To download a copy of the proposed regs, point your browser to: http://edocket.access.gpo.gov/2007/pdf/E7-14827.pdf

Related Topic(s): Benefits - Flexible Benefits