For many years the rules governing cafeteria plans had
been a combination of temporary, proposed, and final regulations plus
assorted other rulings. The IRS’s 2007 proposed regulations replace
all prior proposed regulations and provide a compilation of the IRS
regulation of these plans. The proposed regulations, in most instances,
do not differ in substance from prior rulings and may be relied on
pending final regulations (which, as of this writing, have still not
been issued). The proposed regulations provide that unless a plan
satisfies the requirements of IRC Sec. 125 and the regulations, the
plan is not a cafeteria plan. The reasons that a plan would fail to
satisfy these requirements include 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-or-lose rule; allowing
employees to revoke elections or make new elections during a plan
year, except as provided by IRS Reg. Sec. 1.125-4; 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 IRS-proposed regulations; and failing
to comply with grace period rules.
Definition of a Sec. 125 cafeteria plan. A cafeteria plan must be a separate written plan that complies with
the requirements of IRC Sec. 125 and IRS regulations, that is maintained
by an employer for employees, and that is operated in compliance with
the requirements of Sec. 125 and the regulations. Participants in
a cafeteria plan must be permitted to choose among at least one permitted
taxable benefit (for example, cash, including salary reduction) and
at least one qualified benefit. A plan offering only elections among
nontaxable benefits is not a cafeteria plan. Also, a plan offering
only elections among taxable benefits is not a cafeteria plan. Finally,
a cafeteria plan must not, with certain exceptions, provide for deferral
of compensation. The exceptions from the ban on deferral of compensation
are 401(k) plans, certain plans maintained by educational institutions
to provide for postretirement group life insurance, and HSAs.
Written plan requirement. A cafeteria
plan must be in writing and must be operated in accordance with the
written plan terms. An amendment to a cafeteria plan must also be
in writing. IRS-proposed regulations require that the written plan
do the following:
• Specifically describe all benefits;
• Set forth the rules for eligibility to participate and
the procedure for making elections;
• Provide that all elections are irrevocable (except to
the extent that the plan includes the optional change in status rules); and
• State how employer contributions may be made under the
plan (for example, salary reduction or nonelective employer contributions),
the maximum amount of elective contributions, and the plan year.
If the plan includes an FSA, the written plan must include
provisions complying with the uniform coverage rule and the use-or-lose
rule. IRS-proposed regulations require that the written cafeteria
plan specify that only employees may participate in the cafeteria
plan and that all provisions of the written plan apply uniformly to
IRS-proposed regulations also provide that the written
plan for a self-insured medical reimbursement plan, dependent care
assistance program, or an adoption assistance program offered through
a cafeteria plan that satisfies the cafeteria plan written plan requirement
also satisfies the written plan requirements for these benefits that
apply when they are not provided through a cafeteria plan. Alternatively,
a self-insured medical reimbursement plan, a dependent care assistance
program, or an adoption assistance program is permitted to satisfy
their specific requirements through a separate written plan, and not
as part of the written cafeteria plan.
In describing the benefits available through the cafeteria
plan, the written cafeteria plan may incorporate, by reference, benefits
offered through other separate written plans, such as a 401(k) plan
or a dependent care assistance program, without describing, in full,
the benefits established through these other plans. But, for example,
if the cafeteria plan offers different maximum levels of coverage
for dependent care assistance programs, the descriptions in the separate
written plan must specify the available maximums.
Individuals who may participate in a cafeteria
plan. All participants in a cafeteria plan must be employees.
IRS-proposed regulations provide that employees include common-law
employees, leased employees, and full-time life insurance salespersons.
Former employees (including laid-off employees and retired employees)
may participate in a plan, but a plan may not be maintained predominantly
for former employees. A participant’s spouse or dependents may receive
benefits through a cafeteria plan although they cannot participate
in the cafeteria plan. Sole proprietors, partners, and directors of
corporations are not employees and may not participate in a cafeteria
plan. In addition, the proposed regulations clarify that shareholders
owning 2 percent of an S corporation are not employees for purposes
of Sec. 125.
Dependent children. An employee’s
child who has not attained the age of 27 as of the end of the employee’s
taxable year is eligible to receive benefits under a Sec. 125 plan.
An employer may assume an employee’s taxable year is the calendar
year. Previously, a child who was not a dependent had to be younger
than either the age of 19 or the age of 24, if enrolled in school.
For this purpose, a child is the son, daughter, stepson, or stepdaughter
of the employee, including those who are legally adopted or lawfully
placed with the employee for legal adoption and “eligible foster children,”
defined as individuals who are placed with an employee by an authorized
placement agency or by judgment, decree, or court order. This provision
applies to a child of the employee even if the child is not the employee’s
dependent within the meaning of IRC Sec. 152(a). Thus, the age limit, residency,
support, and other tests described in Sec. 152(c) do not apply to
a child for this purpose.
Because the exclusion of coverage and reimbursements
from an employee’s gross income under IRC Secs. 106 and 105(b) carries
forward automatically to the definition of qualified benefits for
Sec. 125 cafeteria plans, including health FSAs, the IRS has stated
it intends to amend the regulations on change of status events that
justify a midyear change in cafeteria plan elections to include change
in status events affecting nondependent children under the age of
27, including becoming newly eligible for coverage or eligible for
coverage beyond the date on which the child otherwise would have lost
it. Employers may permit employees to increase their FSA elections
to reflect coverage of children under the age of 27. Employers may
allow this change under their cafeteria plan even if the cafeteria
plan has not yet been amended to reflect the change in coverage options.
Election between taxable and nontaxable benefits. A cafeteria plan must offer employees an election among only permitted
taxable benefits (including cash) and qualified nontaxable benefits.
For purposes of Sec. 125, "cash" means cash from current compensation
(including salary reduction), payment for annual leave, sick leave,
other PTO, severance pay, property, and certain after-tax employee
contributions. Distributions from qualified retirement plans are not
cash or taxable benefits for purposes of Sec. 125.
Qualified benefits. In general,
in order for a benefit to be a qualified benefit for purposes of Sec.
125, the benefit must be excludable from employees’ gross income under
a specific provision of the IRC and must not defer compensation, except
as specifically allowed in IRC Sec. 125(d)(2)(B), (C), or (D). Examples
of qualified benefits include the following:
• Accident and health benefits
• Adoption assistance
• Dependent care assistance
• Group term life insurance
Sec. 125 plan year. A Sec. 125 plan
year must be 12 consecutive months and must 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.
No deferral of compensation. Qualified
benefits must be current benefits. In general, a cafeteria plan may
not offer benefits that defer compensation or operate to defer compensation.
In general, benefits may not be carried over to a later plan year
or used in one plan year to purchase benefits to be provided in a
later plan year. For example, life insurance with a cash value buildup
or group term life insurance with a permanent benefit defers the receipt
of compensation and thus is not a qualified benefit.
The proposed regulations clarify whether certain benefits
and plan administration practices defer compensation. For example,
the regulations permit an accident and health insurance policy to
provide certain benefit features that apply for more than 1 plan year,
such as reasonable lifetime limits on benefits, level premiums, premium
waiver during disability, guaranteed renewability of coverage, coverage
for specified accidental injury or specific diseases, and the payment
of a fixed amount per day for hospitalization. But these insurance
policies must not provide an investment fund or cash value to pay
premiums, and no part of the premium may be held in a separate account
for any beneficiary.
The proposed regulations also provide that the following
benefits and practices do not defer compensation: a long-term disability
policy paying benefits over more than 1 plan year; reasonable premium
rebates or policy dividends; certain 2-year lock-in vision and dental
policies; certain advance payments for orthodontia; salary reduction
contributions in the last month of a plan year used to pay accident
and health insurance premiums for the first month of the following
plan year; reimbursement of expenses for durable medical equipment;
and allocation of experience gains (forfeitures) among participants.
Paid time off (PTO). A cafeteria
plan may include elective PTO (that is, vacation days, sick days,
or personal days) as a permitted taxable benefit through the plan.
A plan may permit employees to receive more PTO than the employer
otherwise provides to the employees on a nonelective basis, but only
if the inclusion of elective PTO off through the plan does not operate
to permit the deferral of compensation. A plan that offers only the
choice of cash or PTO is not a cafeteria plan.
In order to avoid deferral of compensation, the cafeteria
plan must preclude any employee from using the PTO or receiving cash
in a subsequent plan year in exchange for any portion of the elected
PTO remaining unused as of the end of the plan year. For example,
a plan that offers employees the opportunity to purchase PTO (or to
receive cash or other benefits through the plan in lieu of PTO) is
not a cafeteria plan if employees who purchase the PTO for a plan
year are allowed to use any unused PTO in a subsequent plan year.
This is the case even though the plan does not permit the employee
to convert, in any subsequent plan year, the unused PTO into any other
In determining whether a plan providing PTO operates
to permit the deferral of compensation, a cafeteria plan must provide
that employees are deemed to use PTO in the following order:
First: Nonelective PTO (that is, PTO
that the employee has accrued that was not purchased through the cafeteria
Second: Elective PTO
The cafeteria plan must provide that all unused elective
PTO (determined as of the last day of the plan year) must either be
paid in cash or be forfeited. This provision must apply uniformly
to all participants in the cafeteria plan. The employee must receive
the cash on or before the last day of the cafeteria plan’s plan year
to which the elective contributions used to purchase the unused elective
PTO relates. If the cafeteria plan provides for forfeiture of unused
elective PTO, the forfeiture must be effective on the last day of
the plan year to which the elective contributions relate. There is
no grace period to use PTO.
Nonqualified benefits. A cafeteria
plan must not offer any of the following benefits:
• Archer medical savings accounts (MSAs)
• Athletic facility usage
• De minimis benefits
• Educational assistance (including tuition reduction)
• Employee discounts
• Employer-provided cell phones
• Lodging on the employer’s business premises
• Moving expenses reimbursement
• No-additional-cost services
• Transportation benefits
• Working condition benefits
An HSA funded through a cafeteria plan, however, may
be used to pay premiums for long-term care insurance or for long-term
care services. The proposed regulations clarify that group term life
insurance for an employee’s spouse, child, or dependent; and elective
deferrals to 403(b) plans are also nonqualified benefits. A plan offering
any nonqualified benefit is not a cafeteria plan.
After-tax employee contributions. A cafeteria plan is allowed to offer after-tax employee contributions
to pay for qualified benefits or PTO. A cafeteria plan may offer only
the taxable benefits that are specifically permitted. Nonqualified
benefits may not be offered through a cafeteria plan, even if paid
with after-tax employee contributions.
Employer contributions through salary reduction. Employees electing to pay for a qualified benefit through salary
reduction are electing to forgo salary and instead to receive a benefit
that is excludable from gross income if it is provided by employer
contributions. The employee is treated as receiving the qualified
benefit from the employer in lieu of the taxable benefit. A cafeteria
plan may also impose reasonable fees to administer the cafeteria plan,
which may be paid through salary reduction. A cafeteria plan may,
but does not have to, allow employees to pay for any qualified benefit
with after-tax employee contributions.
A cafeteria plan must not discriminate in favor of highly
compensated individuals (HCIs) as to eligibility for benefits, discriminate
in favor of highly compensated participants (HCPs) as to contributions
and benefits, or discriminate in favor of key employees as to utilization
of benefits. If the plan discriminates, the benefits of these employees
are included in their taxable income.
Definitions. A "highly compensated
individual" is any employee who, for the prior year (or the current
year for a new employee), is an officer, 5 percent shareholder, or
employee whose compensation exceeds the IRC Sec. 414(q)(1)(B) amount (currently $120,000) and is in the top-paid group of employees.
A "highly compensated participant" is an HCI who is eligible to participate
in the plan. Statutory nontaxable benefits are qualified benefits
excludable from gross income plus group term life insurance exceeding
$50,000. Total benefits are qualified benefits plus taxable benefits.
Eligibility test rules. The benefit
eligibility test requires that a cafeteria plan not discriminate in
favor of HCIs as to eligibility to participate in the plan in the
plan year being tested. For the eligibility test, a plan may exclude
employees who do not meet a minimum service requirement only if the
plan requires 3 years of service for participation. However, employees
with less than 3 years of service may be treated as if they are covered
by a separate plan.
Benefit availability test rules. The benefit availability test requires that either qualified benefits
and total benefits or employer contributions (including salary reduction
contributions) for statutory nontaxable benefits and for total benefits
do not discriminate in favor of HCPs. For this test, all similarly
situated employees must have the same opportunity to elect benefits,
and HCPs must not disproportionately utilize or elect qualified benefits.
Utilization test rules. The utilization
test requires that the statutory nontaxable benefits for key employees
not exceed 25 percent of the aggregate statutory nontaxable benefits
for all employees. A premium-only plan satisfies this test if it satisfies
the eligibility test.
All members of a controlled group are treated as a single
employer for purposes of these tests. Employers may, but need not,
aggregate two or more cafeteria plans for purposes of the tests, as
long as the plans are not aggregated to manipulate the results. If
discriminatory benefits are provided to highly compensated participants,
to highly compensated individuals, or to key employees, the benefits
are included in these employees’ gross income.
A small business may adopt a "simple cafeteria plan"
that provides a safe harbor from nondiscrimination requirements. A
simple cafeteria plan must be established and maintained by an eligible
employer and meet specific contribution, eligibility, and participation
requirements in order to qualify for the safe harbor. This provision
should encourage small employers that would otherwise be vulnerable
under the nondiscrimination rules to adopt a cafeteria plan.
Eligible employer. An eligible employer
for any year is an employer that employed an average of 100 or fewer
employees on business days during either of the 2 preceding years.
A year may be taken into account only if the employer was in existence
throughout the year. If an employer was not in existence throughout
the preceding year, the determination of the number of employees is
based on the average number of employees that it is reasonably expected
the employer will employ on business days in the current year.
Treatment of growing employers. An
employer that was an eligible employer for any year is treated as
an eligible employer for subsequent years when it has grown to more
than 100 employees until the employer employs an average of 200 or
more employees on business days during any preceding year preceding
any such subsequent year.
Contribution requirements. The contribution
requirements are met if the plan requires the employer, without regard
to whether a qualified employee makes any salary reduction contribution,
to make a contribution to provide qualified benefits under the plan
on behalf of each qualified employee in an amount equal to:
• A uniform percentage (not less than 2 percent) of the
employee’s compensation for the plan year, or
• An amount that is not less than the lesser of 6 percent
of the employee’s compensation for the plan year or twice the amount
of the salary reduction contributions of each qualified employee.
The contribution requirements will not be met if, under
the plan, the rate of contributions for any salary reduction contribution
of a highly compensated or key employee at any rate of contribution
is greater than that for an employee who is not a highly compensated
or key employee. The contribution requirement does not prohibit an
employer from making additional contributions to provide qualified
benefits under the plan.
Minimum eligibility and participation requirements. The minimum eligibility and participation requirements are generally
met for any year if:
• All employees who had at least 1,000 hours of service
for the preceding plan year are eligible to participate, and
• Each employee eligible to participate in the plan may,
subject to terms and conditions applicable to all participants, elect
any benefit available under the plan.