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CCH® BENEFITS — 8/9/07

New Proposed Cafeteria Plan Rules Expand Written Plan Document Requirements, Clarify Discrimination Testing

From Spencer's Benefits Reports: On August 6, the Internal Revenue Service published in the Federal Register a comprehensive set of proposed regulations governing the operation of IRC Sec. 125 cafeteria plans. The proposed rules include a variety of new guidance, including expanded written plan document requirements and easier to understand discrimination testing rules.

The new proposed rules come 23 years after the first proposed Sec. 125 rules were issued but never finalized. The IRS has withdrawn all of the older proposed and temporary rules and stated that the new proposed rules, now the only comprehensive guidance regarding Sec. 125, may be relied on until final rules are published.

The new proposed rules explain, clarify and/or modify at least six statutory changes, five sets of proposed and temporary regulations, and more than a dozen revenue rulings, revenue procedures, and notices issued since 1984.A hearing on the proposed rules is scheduled for November, and the regulations are proposed to be effective in 2009.

Structure Of Rules, Incorporation Of New Laws

The Sec. 125 rules will be organized as follows:

• general rules on qualified and nonqualified benefits in cafeteria plans (new Proposed Reg. Sec.1.125-1);
• general rules on elections (new Proposed Reg. Sec.1.125-2);
• effect of the Family and Medical Leave Act (FMLA) on the operation of cafeteria plans (previously issued Reg. Sec.1.125-3);
• permitted election changes (previously issued Reg. Sec. 1.125-4);
• general rules on flexible spending arrangements (FSAs) (new Proposed Reg. Sec.1.125-5);
• general rules on substantiation of expenses for qualified benefits (new Proposed Reg. Sec.1.125-6); and
• nondiscrimination rules (new Proposed Reg. Sec.1.125-7).

The new proposed regulations reflect changes in tax law since the prior regulations were proposed, including the following:

• the change in the definition of dependent (IRC Sec. 152);
• the addition of the following as qualified benefits: adoption assistance (IRC Sec. 137), health savings accounts (HSAs) (IRC Secs. 223, 125(d)(2)(D), and 4980G), and qualified HSA distributions from health care FSAs (IRC Sec. 106(e));
• the prohibition against long term care insurance and long term care services (IRC Sec. 125(f)); and
• the addition of the key employee concentration test in IRC Sec. 125(b)(2).
  

Several Significant Differences

Many provisions of the new proposed rules incorporate elements of the prior proposed rules or other guidance. However, a significant number of provisions are new, including these:

No cafeteria plan. The plan is not a cafeteria plan if, due to the following actions, it fails to satisfy the requirements of Sec. 125 and the regulations, due to the following:

• offering nonqualified benefits;
• not offering an election between at least one permitted taxable benefit and at least one qualified benefit;
• deferring compensation;
• failing to comply with the uniform coverage rule or use-it-or-lose-it rule;
• allowing employees to revoke elections or make new elections during a plan year, except as provided in the rules;
• failing to comply with substantiation requirements;
• paying or reimbursing expenses incurred for qualified benefits before the effective date of the cafeteria plan or before a period of coverage;
• allocating experience gains (forfeitures) other than as expressly allowed in the new proposed regulations; and
• failing to comply with grace period rules.
  

Written plan requirements. According to the proposed rules, a written cafeteria plan must contain all of the following information:

1. a specific description of each of the benefits available through the plan, including the periods during which the benefits are provided;
2. rules governing participation, and specifically requiring that all participants in the plan be employees;
3. procedures governing employees’ elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective, and providing that elections are irrevocable, except to the extent that the optional change in status rules in Reg. Sec. 1.125-4 are included in the cafeteria plan;
4. the manner in which employer contributions may be made under the plan. For example, through an employee’s salary reduction election or by nonelective employer contributions;
5. the maximum amount of employer contributions available to any employee through the plan, by stating: 

   (A) the maximum amount of salary reduction available to any employee through the plan, expressed as a maximum dollar amount or a maximum percentage of compensation; and
   (B) for contributions to 401(k) plans, the maximum amount of elective contributions available to any employee through the plan, expressed as a maximum dollar amount or maximum percentage of compensation that may be contributed as elective contributions through the plan by employees;

    

6. the plan year of the cafeteria plan;
7. if the plan offers paid time off, the required ordering rule for use of nonelective and elective paid time off;
8. if the plan includes FSAs (as defined in Reg. Sec.1.125-5(a)), the plan’s provisions complying with any additional requirements for those FSAs;
9. if the plan includes a grace period, the plan’s provisions complying with the grace period rules; and
10. if the plan includes distributions from a health care FSA to employees’ HSAs, the plan’s provisions complying with the applicable rules.

Group term life coverage. The proposed regulations provide that the entire amount of salary reduction and employer flex credits for group-term life insurance coverage on the life of an employee is excludable from an employee’s gross income.

The new proposed regulations differ from Notice 89-110 (C.B. 1989-2 447), which provides that an employee includes in gross income the greater of the Table I cost of group term life insurance coverage exceeding $50,000 or the employee’s salary reduction and employer flex credits for excess group term life insurance coverage. The new proposed regulations provide instead that the employee includes in gross income the Table I cost of the excess coverage (minus all after-tax contributions by the employee for group term life insurance coverage) and that the entire amount of salary reduction and employer flex credits for group term life insurance coverage on the life of the employee is excludable from the employee’s gross income.

Individual premiums. The new proposed regulations specifically permit a cafeteria plan (but not a health care FSA) to pay or reimburse substantiated individual accident and health insurance premiums. In addition, a cafeteria plan may provide for payment of COBRA premiums for an employee.

Plan year. The new proposed regulations require that a cafeteria plan year be 12 consecutive months and be set out in the written cafeteria plan. A short plan year (or a change in plan year resulting in a short plan year) is permitted only for a valid business purpose. A change in plan year resulting in a short plan year, for other than a valid business purpose, is disregarded. If a principal purpose of a change in plan year is to circumvent the rules of Sec. 125, the change in plan year is ineffective.

Paid leave. Under the prior proposed regulations, permitted taxable benefits included various forms of paid leave. Since the prior proposed regulations were issued, many employers have recharacterized and combined vacation days, sick leave, and personal days into a single category of “paid time off.” The new proposed regulations use the term “paid time off” to refer to vacation days and other types of paid leave.

Electronic elections. New elections and revocations or changes in elections can be made electronically using the safe harbor for electronic elections in Reg. Sec.1.401(a)-21. Only an employee can make an election or revoke or change his or her election. An employee’s spouse or dependent may not make an election under a cafeteria plan and may not revoke or change an employee’s election.

Dependent care FSA. A new optional rule permits an employer to reimburse through a dependent care FSA, a terminated employee’s qualified dependent care expenses incurred after termination if all IRC Sec. 129 requirements are otherwise satisfied.

Nondiscrimination testing. The new proposed regulations define highly compensated individual or participant consistent with the IRC Sec. 414(q) definition of highly compensated employee.

These regulations provide an objective discrimination test to determine when the actual election of benefits is discriminatory. Specifically, these regulations provide that a cafeteria plan must give each similarly-situated participant a uniform opportunity to elect qualified benefits, and that highly compensated participants must not actually disproportionately elect qualified benefits.

The proposed rules also create a safe harbor for premium-only plans that satisfy the safe harbor eligibility provisions of Reg. Sec. 1.410(b)-4.

Dual status. If an individual is an employee of an employer and also provides services to that employer as an independent contractor or director (and as such normally would not be eligible for Sec. 125 benefits), the individual is eligible to participate in that employer’s cafeteria plan solely in his or her capacity as an employee. This rule does not apply to partners or to 2% shareholders of a Subchapter S corporation.

Comments, Hearing

In addition to comments on the proposed rules, the IRS also requests comments on the following issues:

1. whether multiple employers (other than members of a controlled group) may sponsor a single cafeteria plan;
2. whether salary reduction contributions may be based on employees’ tips and how that would work; and
3. for cafeteria plans adopting the change in status rules, when a participant has a change in status and changes his or her salary reduction amount, how should the participant’s uniform coverage amount be computed after the change in status?

Written or electronic comments on the proposed rules must be received by November 5. Written comments should be submitted to CC:PA:LPD:PR (REG-142695-05), Room 5203, IRS, P.O. Box 7604, Ben Franklin Station, Washington, DC 20044. Electronic comments should be sent via the Federal eRulemaking Portal at http://www.regulations.gov (IRS REG-142695-05).

A hearing is scheduled for November 15, at 10 a.m.

For further information regarding the rules, contact the principal author, Mireille T. Khoury, at (202) 622-6080. Concerning submissions of comments, the hearing, and/or to be placed on the building access list to attend the hearing, contact Oluwafunmilayo Taylor at (202) 622-7180.

For more information on this and related topics, consult the CCH Pension Plan Guide, CCH Employee Benefits Management, and Spencer's Benefits Reports.

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