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Section 125 of the IRC allows employees to pay for a variety of benefits with pretax dollars, thus reducing the amount of their wages that are subject to federal income and employment taxes. Employers also get a tax savings because their share of employment taxes is also reduced. The "qualified" benefits that may be provided through Section 125, or flex or cafeteria, plans include health insurance, disability insurance, group term life insurance, group legal services coverage, elective contributions to 401(k) plans, adoption assistance, and medical and childcare reimbursements. The Internal Revenue Service (IRS) says that both a health savings account (HSA) and a high-deductible health plan (HDHP) associated with the HSA may be offered as options under a cafeteria plan. Thus, an employee may elect to have pretax salary reductions contributed as employer contributions to an HSA and an HDHP. Certain benefits such as long-term care insurance may not be funded with pretax dollars through a 125 plan.
There are three major types of flexible benefit plans, including:
• The premium-only plan, which is the simplest and least expensive to administer;
• The childcare, adoption assistance, and medical flexible spending account (FSA); and
• The full-scale flexible benefit plan (aka cafeteria plan), which is the most complicated to operate.
An employer may adopt each or all of the flexible benefit plan types.
Warning: Flexible benefit plans involve complex tax rules and should not be implemented without consulting a tax adviser who specializes in employee benefits.
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 all participants.
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, but 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. 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.
The exclusion of coverage and reimbursements from an employee’s gross income under IRC Secs. 106 and 105(b) carried forward automatically to the definition of qualified benefits for Sec. 125 cafeteria plans, including health FSAs. 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 paid time off (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
• HSAs
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.
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 employees to convert, in any subsequent plan year, the unused PTO into any other benefit.
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 plan)
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 relate. 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
• Meals
• 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, a 5 percent shareholder, or an employee whose compensation exceeds the IRC Sec. 414(q)(1)(B) amount (currently $130,000) 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 HCPs, to HCIs, 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.
A POP allows employees to have their share of group insurance premiums (for employee and dependent coverage) deducted from their paychecks on a pretax basis. A typical moderately paid employee's federal income taxes and Social Security (Federal Insurance Contributions Act (FICA)) taxes will be reduced by almost 23 percent of the amount applied toward the premium. Employees in higher tax brackets will save even more. State income taxes will also be reduced. The employer's share of FICA, unemployment compensation (Federal Unemployment Tax Act (FUTA)) taxes, and sometimes workers' compensation premiums is also reduced. Employers will save between 8 percent and 10 percent of the amount by which the employees' salary is reduced to pay a group insurance premium. This savings will usually more than pay for the cost of starting up and administering the plan.
FSAs allow employees to pay for healthcare expenses, childcare bills, or adoption costs with pretax dollars by choosing an amount at the beginning of the plan year to be withheld from wages during the course of the year and deposited into a separate account. The employee is reimbursed out of the account for qualifying medical/dental or childcare expenses incurred during that year. The tax savings to both employees and the employer under an FSA are similar to those provided by a POP.
This type of setup is somewhat more complicated to administer than a POP and is often combined with a POP as a single plan. In addition to start-up costs, ongoing administration will include the cost of keeping track of employee contributions, processing and paying reimbursement claims, annual reenrollment (including communication materials to convince employees to participate), annual reports, changing reimbursement amounts during the year when permitted, and the addition of new participants.
Salary reduction contributions may be made at whatever interval the employer selects, including ratably over the plan year based on the employer’s payroll periods or in equal installments at other regular intervals (for example, quarterly installments). These intervals must apply uniformly to all participants.
Only expenses for qualified benefits incurred after the later of the effective date or the adoption date of an FSA may be reimbursed under the FSA. Similarly, if a plan amendment adds a new qualified benefit, only expenses incurred after the later of the effective date or the adoption date are eligible for reimbursement. An FSA may pay or reimburse only expenses for qualified benefits incurred during a participant’s period of coverage.
After an employee incurs an expense for a qualified benefit during the coverage period, the expense must be substantiated before it may be paid or reimbursed. All expenses must be substantiated (substantiating only a limited number of total claims or not substantiating claims below a certain dollar amount does not satisfy the requirements in the proposed regulations). FSAs for dependent care assistance and adoption assistance must follow the substantiation procedures applicable to health FSAs.
In 2005, the IRS modified its long-standing rule that a reimbursable expense must have been incurred during the plan year during which the employee contributed the funds to the medical or childcare FSA (IRS Notice 2005-42). Now, employers may offer a 2-month-and-15-day grace period during which a participant who has unused contributions or benefits for a particular qualifying benefit from the just-ended plan year, and who incurs qualifying expenses for that benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that a participant may have as long as 14 months and 15 days to use benefits or contributions for a plan year before those amounts are forfeited.
Plan amendment required. An employer may adopt a grace period for current plan year (and subsequent plan years) by amending the plan document before the end of the current year.
An FSA is permitted to have a runout period designated by the employer. A "runout period" is a period after the end of the plan year (or grace period) during which a participant can submit a claim for reimbursement for a qualified benefit incurred during the plan year (or grace period). This means that a plan may provide a deadline on or after the end of the plan year (or grace period) for submitting a claim for reimbursement for the plan year. Any runout period must be provided on a uniform and consistent basis for all participants.
IRS Notice 2013-71 (located at http://www.irs.gov/pub/irs-drop/n-13-71.pdf) modifies the former “use-it-or-lose-it” rule for health FSAs, under which an employee would forfeit all contributions and benefits that remained unused by the end of the plan year (or applicable grace period).
Now, employers may permit plan participants to carry over up to $550 of their unused health FSA balances remaining at the end of a plan year. They may use that money at any time during the following year.
Employers are not required to add the carryover option, but if they decide to add it, they must amend their plans in a timely manner and make sure they meet all the conditions for offering the carryover. Employers may choose to specify a carryover amount lower than $550.
Note that an FSA plan cannot offer both the carryover option and a grace-period option. It must be one or the other (or neither).
The Consolidated Appropriations Act (CAA) of December 2020 provided many new options for allocating FSA funds.
A grace period, usually limited to 2 1/2 months after the end of a plan year, may be extended for a full year—e.g., until the end of 2021 for amounts from 2020. It is up to the plan sponsor whether to permit such an extension; a plan with a carryover feature may choose instead to allow an unlimited carryover rather than the usual $550 maximum.
In 2021, participants in a health or dependent care FSA may be allowed to change their contribution amount on a prospective basis at any time during the year, regardless of whether any of the usual criteria for a midyear election change are met. Employees who stop participating in an FSA during 2021 or 2022 may be given until the end of the year to incur medical expenses and spend down their remaining balances.
These FSA changes are subject to the plan sponsor’s discretion, and they’re not all or nothing. Employers may adopt this relief for some but not all participants, provided the nondiscrimination tests are met. Employers will want to consider their workforce’s specific needs and consult with their service providers regarding the potential administrative complications.
For example, reduced access to healthcare and childcare services may have left employees with excess funds in their FSAs, or participants may wish to adjust the amounts already elected for 2021 to reflect the new options. But employers may need to consider the effect of such relief on HSA eligibility and, in the dependent care context, certain tax reporting requirements.
IRS Notice 2021-15 provides detailed guidance on these CAA provisions, including examples of how the increased carryover would interact with the extended period for incurring claims or, in the case of dependent care FSAs, the temporary increase in the age limit from 13 to 14.
As a practical matter, being able to carry over an entire year’s amount or extend the grace period for a full year amounts to the same relief, “as both provisions allow all unused benefits remaining for plan years ending in 2020 and 2021 to be made available for the same benefit (medical care expenses or dependent care expenses) incurred in the immediately subsequent plan year,” the IRS noted. However, the two types of relief interact differently with an extended period for incurring claims.
The American Rescue Plan Act (ARPA) of March 2021 temporarily increased the allowable contribution limit for dependent care FSAs more than twofold (see “Dependent Care FSAs,” below).
The Heroes Earnings Assistance and Relief Tax Act of 2008 amended the provisions of Sec. 125 to give employees called to active duty access to the funds in a medical FSA. A medical FSA may provide for a "qualified reservist distribution" (QRD), which is a distribution of all or part of an employee's account to an employee called to active military service. Such a distribution must be:
• Made to an individual who was ordered or called to active military duty for a period in excess of 179 days or for an indefinite period; and
• Made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period.
A cafeteria plan is not required to provide for a QRD. The decision of whether to allow a QRD from a health FSA is optional with the employer. A QRD may not be made before the cafeteria plan is amended to provide for a QRD from a health FSA. The proposed IRS cafeteria plan regulations, however, allow that a plan may be amended at any time on a prospective basis (Prop. IRS Reg. Sec. 1.125-1(c)). The QRD amendment must apply uniformly to all participants in the cafeteria plan.
Who may receive a QRD? An employee who is a member of a military reserve component and is ordered or called to active duty for a period of 180 days or more or for an indefinite period may request a QRD. A QRD may not be made based on an order or call to active duty of any individual other than the employee, including the spouse of the employee. After an employee requests a QRD and before the employer may distribute an amount, the employer must first receive a copy of the order or call to active duty. An employer may rely on the order or call to determine the period that the employee has been ordered or called to active duty. If the order or call specifies that the period of active duty is for 180 days or more or is indefinite, the employee is eligible for a QRD, and the employee’s eligibility is not affected if the actual period of active duty is less than 180 days or is otherwise changed. If the period specified in the order or call is less than 180 days, a QRD is not allowed. However, subsequent calls or orders that increase the total period of active duty to 180 days or more will qualify an employee for a QRD. For example, if an employee is ordered or called to active duty for 120 days, and the order or call is subsequently extended for an additional 60 days, that individual qualifies for a QRD.
Reserve components include:
• The Army National Guard of the United States,
• The Army Reserve,
• The Navy Reserve,
• The Marine Corps Reserve,
• The Air National Guard of the United States,
• The Air Force Reserve,
• The Coast Guard Reserve, and
• The Reserve Corps of the Public Health Service.
When a QRD must be requested and distributed. An employee must request a QRD on or after the date of the order or call to active duty and before the last day of the plan year (or grace period, if applicable) during which the order or call to active duty occurred. An employer must pay the QRD to the employee within a reasonable time, but not more than 60 days after the request for a QRD has been made. A QRD may not be made for a plan year ending before the order or call to active duty. In addition, a QRD may be made only on or after the effective date of amendment of the plan to provide for QRDs.
The amount available as a QRD. The cafeteria plan amendment providing for QRDs should indicate how the plan will determine an employee’s health FSA balance for purposes of making QRDs. The cafeteria plan may provide that the amount available as a QRD will be:
• The entire amount elected for the health FSA for the plan year minus health FSA reimbursements received as of the date of the QRD request;
• The amount contributed to the health FSA as of the date of the QRD request minus health FSA reimbursements received as of the date of the QRD request; or
• Some other amount (not exceeding the entire amount elected for the health FSA for the plan year minus reimbursements).
If the cafeteria plan amendment does not indicate how the plan will determine the amount available as a QRD, the amount available is the amount contributed to the health FSA as of the date of the QRD request minus health FSA reimbursements received as of that date.
QRD procedures. A cafeteria plan may specify a process for employees to request a QRD, including how many QRDs may be made for an employee during the same plan year. A plan must permit an employee to submit health FSA claims for medical expenses incurred before the date a QRD is requested and must pay or reimburse substantiated claims for those medical expenses. A plan may either permit employees to continue to submit health FSA claims for medical expenses incurred before the end of the health FSA plan year (and grace period, if applicable) or terminate an employee’s right to submit claims.
Application of cafeteria plan nondiscrimination rules. QRDs must be uniformly available to all plan participants. The QRD amounts are disregarded for purposes of the cafeteria plan nondiscrimination rules.
Taxation. A QRD is included in the gross income and wages of the employee and is subject to employment taxes. The employer must report the QRD as wages on the employee’s Form W-2 for the year in which the QRD is paid to the employee. The amount reported as wages is reduced by any amount in the health FSA representing after-tax contributions (such as Consolidated Omnibus Budget Reconciliation Act (COBRA) continuation premiums).
Annual FSA contributions are limited; the amount is adjusted periodically by the IRS. FSA contributions from all sources cannot exceed $2,750 for tax year 2021.
An expense may not be reimbursed if it is reimbursable under any other form of health insurance. Reimbursable expenses include most out-of-pocket medical and dental expenses not covered by health insurance. These include copayments, deductibles, and many items that are not covered by many insurance plans, such as eyeglasses, and travel expenses that are primarily for and necessary for obtaining medical care. IRS Publication 502, which deals with medical expenses that qualify as itemized deductions, applies in most cases to expenses eligible for reimbursement under an FSA.
Substantiation of expenses. To be eligible for reimbursement, an expense must be substantiated by submission of a receipt or through further review. If the employer is provided with information from an independent third party (such as an explanation of benefits (EOB) from an insurance company) indicating the date of the service and the employee’s responsibility for payment for that service (i.e., coinsurance payments and amounts below the plan’s deductible), the claim is fully substantiated without the need for submission of a receipt by the employee or further review (IRS Notice 2006-69).
Prohibition against self-substantiation. Self-substantiation of an expense by an employee-participant does not constitute the required substantiation. For example, a health FSA may not reimburse participants for expenses where the participants only submit information (including via Internet, intranet, facsimile, or other electronic means) describing medical expenses, the amount of the expenses, and the date of the expenses, but do not provide a statement from an independent third party (either automatically or subsequent to the transaction) verifying the expenses. If a plan’s copayment matching system relies on an employee to provide a copayment amount without independent verification of the amount, the expense has not been substantiated. If a plan pays unsubstantiated expenses, all amounts paid from the plan are included in gross income, including amounts paid for medical care whether or not substantiated.
Weight loss programs. Expenses to lose weight are reimbursable under a medical FSA if they are for a treatment for a specific disease diagnosed by a physician (such as obesity, hypertension, or heart disease). This includes fees paid for membership in a weight reduction group and attendance at periodic meetings. Membership dues in a gym, health club, or spa are not reimbursable, but separate fees charged specifically for weight loss activities are. The costs of diet food or beverages are not reimbursable expenses because the diet food and beverages substitute for what is normally consumed to satisfy nutritional needs. However, the cost of special food that exceeds the cost of a normal diet is reimbursable under an FSA if:
• The food does not satisfy normal nutritional needs;
• The food alleviates or treats an illness; and
• The need for the food is substantiated by a physician.
Note: Premiums for medical insurance coverage are not expenses eligible for reimbursement under a medical FSA.
Over-the-counter (OTC) drugs. Under the Affordable Care Act (ACA), FSA funds could not be used to reimburse the cost of OTC medications, except insulin, unless such drugs were obtained by prescription. In 2020, however, a provision of the Coronavirus Aid, Relief, and Economic Security Act repealed this restriction for expenses incurred in 2020 or later.
Expenses do not generally become eligible for reimbursement until the service that gives rise to the expense is performed, not when the plan participant is billed for or pays for the services. This creates a problem for certain kinds of services (such as orthodontic services) where advance payments are required. In a private, nonbinding ruling, the IRS stated that in this kind of situation, it may be impossible to match costs with the provision of particular services. While it may be reasonable for an employee to be reimbursed for the full amount of the up-front payment, noted the IRS, it is not unreasonable to request a breakdown of the bill and to reimburse only those expenses for which services have actually been provided.
Covered expenses must be reimbursed (up to the annual election amount) when the covered individual has submitted documentation proving the expenses. For example, an employee in a calendar plan has elected to have $600 put into a medical reimbursement account for the year, with $50 withheld from each monthly paycheck. If the employee submits receipts for a $700 medical expense in February, the plan must reimburse the employee $600 at that time.
While only medical expenses incurred during the period of coverage are eligible for reimbursement, plans may allow a 2-month-and-15-day grace period after the end of a plan year during which expenses eligible for reimbursement could be incurred and reimbursed from contributions made during the just-ended plan year.
In Notice 2020-29, the IRS temporarily loosened the grace period rules in response to COVID-19. This relief was expanded and extended by the CAA (see “Temporary COVID-19 Relief,” above).
An FSA may reimburse medical expenses through the use of a debit card or stored-value card. The same system may also be used for health reimbursement arrangements (HRAs). The IRS approved an arrangement under which each participating employee was issued a card and certified upon enrollment in the FSA and each plan year thereafter that:
• The card would only be used for eligible medical care expenses.
• Any expense paid with the card had not been already reimbursed.
• The employee would not seek reimbursement under any other plan covering health benefits.
• The certification, which was printed on the back of the card, is reaffirmed each time the card is used.
The cardholder must also agree to acquire and retain sufficient documentation for any expense paid with the card, including invoices and receipts, where appropriate. The card would be automatically canceled at termination of employment.
Reimbursement restrictions. The use of the card is limited to the maximum dollar amount available in the cardholder's FSA. The card is effective only at merchants or service providers authorized by the employer. An employer may implement this restriction by limiting the card’s use to specified merchant category codes (MCCs) relating to health care. All charges to a card, except those that are automatically substantiated, are to be treated as conditional pending review and substantiation.
Correction procedures. The plan document must include a correction procedure in the event of a nonqualifying reimbursement. The procedure may require the employee to pay back any improper payments. If this does not work, the employer may withhold the amount of the improper payment from the employee’s wages or other compensation. Lastly, the employer may reduce future reimbursements by the improper amount. If correction is unsuccessful, the employer may treat the improper payment like any other business debt.
Automatic substantiation. The IRS said in guidance that it issued in 2003, and has since revisited, that automatic substantiation of health FSA claims is permissible. This guidance includes:
• Revenue Ruling 2003-43, which allows automatic substantiation for matching copayments and recurring expenses;
• Notice 2006-69, which expanded auto-substantiation to include copayment multiples and the inventory information approval system (IIAS);
• Notice 2007-2, which provided an additional year to develop the IIAS and introduced the “90-percent Rule,” an exception to the IIAS requirements that is available to drug stores and pharmacies whose gross receipts for the most recently ended tax year are 90 percent or more from eligible medical expenses as defined by Code Section 213(d); and
• Notice 2008-104, which says that transactions at drug stores and pharmacies to which the 90-percent Rule applies can be auto-substantiated without a receipt or conditionally approved before a receipt is provided.
Medical expenses may be auto-substantiated if incurred at physicians, dentists, vision care offices, hospitals, other qualified medical care providers, and at stores with the MCC assigned to drug stores and pharmacies and to which the 90-percent Rule applies.
The IRS pointed out in Information Letter 2018-0032 the importance of the MCC. A participant tried to use the debit card at a facility that did not have an MCC. As a result, the transaction was denied, even though the expenditure apparently was for medical care.
HRAs are a form of employer-provided medical coverage in which employers fund an account that employees may use to pay medical expenses up to a fixed amount per coverage period (usually a year). The account is generally coupled with high deductible insurance coverage. HRAs are intended to encourage employees to budget their routine medical expenses by allowing unused amounts in their account to be rolled over for potential use in the future. Please see the national Defined Contribution Health Plans section. Because medical care expenses may not be reimbursed from a Sec. 125 health FSA if they are reimbursable under any other health plan, it would appear impractical to have both an FSA and an HRA. The IRS, however, has approved a workaround for this problem if the HRA plan document is amended (before the FSA plan year begins) to specify that coverage under the HRA is available only after expenses exceeding the FSA dollar limit have been paid. Thus, the FSA funds can be used first before the HRA has to be tapped, maximizing the amount of the HRA funds that are rolled over for future use.
The Department of Health and Human Services has stated that, to the extent that a medical FSA meets the definition of an employee welfare benefit plan under the Employee Retirement Income Security Act (ERISA) and pays for medical care, it is a group health plan and is covered by the HIPAA administrative simplification requirements, including the privacy requirements. A plan that has fewer than 50 participants and is self-administered is exempt. Using an FSA debit or credit card to pay for a participant's or beneficiary's out-of-pocket medical expenses at a pharmacy or provider's office is comparable to a transaction between a participant or beneficiary and a provider, not between a health plan (the FSA) and a provider. Therefore, the transaction is not considered to be subject to HIPAA's electronic data interchange requirements. Please see the national Health Information Privacy section.
Under IRC Section 129, employees can exclude from their income certain employer-provided benefits for dependent care assistance, and Section 45(F) lets employers take a tax credit for offering childcare assistance benefits to their employees.
Under a dependent care FSA or other Section 129-qualified dependent care assistance plan (DCAP), only employment-related dependent care expenses qualify for reimbursement. The amount of employer-provided benefits that may be excluded is limited to $5,000 (or $2,500 for a married employee filing separately), though it was temporarily increased in response to the COVID-19 pandemic (see below).
The availability of this income tax exclusion is further limited to the lesser of two amounts: (1) the employee’s earned income; or (2) if the employee is married at the end of the calendar year, the earned income of either the employee or the spouse, whichever is less. This rule eliminates the use of the tax exclusion when one spouse is not employed. Special rules apply, however, in the case of spouses who are full-time students or are incapable of caring for themselves.
Employees who obtain dependent care services for a limited amount of time—that is, a period shorter than an employer’s plan year—cannot enroll in a DCAP for only the portion of the plan year for which they will need services. An employee can obtain the services of a qualified childcare provider for any amount of time they wish, but that employee can only enter into a dependent care FSA if qualifying services will be rendered for the entire period covered by the plan year.
During 2021, ARPA allows deferrals of up to $10,500 instead of the usual $5,000 (for married taxpayers filing separately, the maximum is $5,250 instead of $2,500). Employers choosing to adopt the higher limits in their cafeteria plan have until the end of the plan year to amend the plan accordingly, provided they operate consistently with the amendment in the meantime.
IRS Notice 2021-26 provided guidance on the effect of ARPA and the CAA. Dependent care benefits that would have been excluded from income if used during a given taxable year (that is, 2020 or 2021, as applicable) will remain excludable from gross income if used in the following year (2021 or 2022) due to either a carryover or a grace period. Also, these benefits will not be taken into account when applying the Section 129 exclusion limits to other dependent care benefits available for the taxable years ending in 2021 and 2022.
However, if a cafeteria plan has a noncalendar plan year beginning in 2021 and ending in 2022, the increased exclusion amount will not apply to reimbursement of expenses incurred during the 2022 portion of the plan year.
Elections are generally irreversible unless an event that may trigger a midyear election change occurs (see the discussion of Midyear Election Changes later in this section). Claims have to be reimbursed monthly, or when the total amount of the claims reaches a reasonable minimum amount. Unused amounts are forfeited at the end of the year, but a 2- to 3-month period after the end of the year is often provided for submission of claims. While only dependent care expenses incurred during the period of coverage are eligible for reimbursement, plans may provide for a 2-month-and-15-day grace period after the end of a plan year during which expenses eligible for reimbursement could be incurred and reimbursed from contributions made during the already ended plan year.
An expense is incurred when the service is performed, not when it is billed or paid for. Unlike medical expense reimbursements, the amount of a dependent care reimbursement may be limited to the amount in the employee's account when the claim is made. Ex-employees may be reimbursed for qualified expenses incurred after termination of employment but during the coverage period. In addition, a plan may provide for the reimbursement of a terminated employee’s qualified dependent care expenses incurred after termination, if all IRC Sec. 129 requirements are otherwise satisfied.
Since the exclusion under Section 129 does not cover all dependent care expenses, an employee’s claim for benefits must be verified as an eligible expense before that employee is reimbursed. If a reimbursed expense turns out to be ineligible, the employer may be subject to income tax withholding and Social Security tax obligations regarding the reimbursement.
A reimbursement can be treated as eligible dependent care assistance only when the amount the employee paid would be considered an “employment-related” expense for household and dependent care under IRC Section 21(b)(2). To qualify under this standard, an expense must satisfy the following conditions:
1. The expense must be for the care of (or household services related to) either (a) a dependent under age 13 for whom the employee is the custodial parent and who may be claimed as an exemption on the employee’s federal income tax return, or (b) a spouse or dependent (regardless of age) who is physically or mentally incapable of caring for himself or herself.
2. A service provided outside the household to a dependent or other qualifying person is an eligible expense only if the individual spends at least 8 hours a day in the employee’s household.
3. A service provided outside the employee’s household at a dependent daycare center is an eligible expense only if the center is in compliance with all applicable licensing requirements.
4. The expense must enable the employee (and spouse, if married) to be gainfully employed or to look for gainful employment (which does not include volunteer work).
5. Payments to an employee’s child who is 18 years of age or younger, or to an individual whom the employee may claim as an exemption for federal income tax purposes, are not eligible expenses.
Married employees are generally only eligible for reimbursement if their spouse is also employed. The tax-free reimbursement may not exceed the wages of the lower-paid spouse. Usually expenses for food, clothing, and education are not considered reimbursable. But if these services are incidental to and inseparably part of the care, the full expense is reimbursable, such as the cost of a childcare program that provides both meals and education.
Regulations that the IRS issued in 2008, to implement amendments to Code Section 152, address how to determine who the custodial parent is when the parents are divorced or separated and living apart. In general, the parent with whom a child lives for the greater number of nights during the calendar year may claim the child as an exemption on his or her tax return, unless that parent releases the right to claim the child to the other parent (IRS Reg. Sec. 1.152-4).
A “dependent” under Section 152 is a qualifying child or qualifying relative. Special rules apply to parents who:
• Are divorced or legally separated under a decree of divorce or separate maintenance;
• Are separated under a written separation agreement; or
• Live apart at all times during the last 6 months of the calendar year.
For purposes of Section 152(e), a child resides for a night with a parent if the child sleeps:
• At the parent’s residence (whether or not the parent is present); or
• In the company of the parent when the child does not sleep at a parent’s residence (for example, if the parent and child are on vacation).
Under Section 152(e)(2), through a written release the custodial parent may relinquish the right to claim the child as a dependent. The noncustodial parent must attach the written declaration to his or her tax return to claim a dependency exemption. A declaration must include an unconditional statement that the custodial parent will not claim the child as a dependent for the specified years.
An employer may use a payment card program to provide benefits under a dependent care FSA (IRS Notice 2006-69). Because dependent care expenses may not be reimbursed before the services are provided, an employee using a provider that requires payment before services are performed cannot be reimbursed at the time of payment, even through the use of a payment card program.
The IRS says that an employer may nevertheless adopt the following method to provide reimbursements for dependent care expenses through a payment card program.
Step 1. At the beginning of the plan year or upon enrollment in the plan, the employee is issued a payment card with a zero balance.
Step 2. The employee pays initial expenses to the dependent care provider and substantiates the initial expenses by submitting to the employer or plan administrator a statement from the dependent care provider substantiating the dates and amounts for the services.
Step 3. As soon as the services are provided as indicated by the statement from the dependent care provider, the plan makes available through the payment card an amount equal to the lesser of (1) the previously incurred and substantiated expense or (2) the employee’s total salary reduction amount to date.
Step 4. The employee then uses the amount on the card to pay his or her next installment for future dependent care expenses. The employee pays any amount not covered by the card balance out of pocket.
Step 5. Later card transactions that have been previously approved as to the dependent care provider and time period may be treated as substantiated without further review if the later card transactions are for an amount equal to or less than the previously substantiated amount.
Step 6. The payment process recycles until the end of the year (plus the grace period).
If there is an increase to the previously substantiated amount or a change in the dependent care provider, the employee must submit a statement or receipt from the dependent care provider substantiating the new claimed expense before amounts relating to the increased amount or new provider may be added to the card.
Expenses that are reimbursed tax-free through a dependent care FSA reduce the base amount for calculating the childcare tax credit (IRC Sec. 21). Lower-income employees are more likely to be better off utilizing the tax credit, while higher-bracket employees generally do better under a dependent care FSA. IRS Publication 503 provides information about the childcare tax credit.
Adoption assistance is a qualified benefit that is excludable from gross income if elected through an adoption assistance FSA, and the adoption assistance must satisfy the requirements of IRC Sec. 137. Reimbursable expenses are those incurred for qualified adoption expenses in connection with an employee’s adoption of a child, if the amounts are paid or incurred through an adoption assistance program. Adoption assistance FSAs follow the same rules as apply to dependent care FSAs.
Qualified adoption expenses. The term "qualified adoption expenses" means reasonable and necessary adoption fees, court costs, attorneys' fees, and other expenses that are directly related to and are primarily for the legal adoption of an eligible child by the employee. Qualified expenses may not be incurred for an illegal adoption or in carrying out any surrogate parenting arrangement. Expenses for the adoption by the employee of a child of his or her spouse are not qualified expenses. There are maximum limits on adoption reimbursements that are set by IRC Sec. 137.
Eligible child. The term "eligible child" means any individual who is either less than 18 years of age or physically or mentally incapable of caring for himself or herself.
Special rules for foreign adoptions. In the case of an adoption of a child who is not a citizen or resident of the United States, any qualified adoption expense is not eligible for reimbursement until the adoption becomes final. Any expense that was paid or incurred before the plan year in which the adoption becomes final is considered to have been paid or incurred during the year when the adoption became final.
The most complicated type of flexible benefit plan provides multiple taxable and nontaxable benefit choices in combination with or in addition to a POP/FSA. This type of plan is what is usually thought of as a “cafeteria plan.” While a full cafeteria plan is relatively complicated to administer, it offers employees the most options to personalize their benefit selections. Among the nontaxable benefits that may be offered through a cafeteria plan are disability and health plans, group term life insurance, dependent care assistance, adoption assistance, and elective contributions to a 401(k) cash-or-deferred arrangement. Benefits on the menu may be paid for in several ways, including by employer-provided credits to each employee, employee pretax salary reductions that may be used to purchase nontaxable benefits, and employee after-tax dollars that may be used to purchase taxable benefits included on the menu. A full cafeteria plan may also allow employees to buy and sell the value of vacation days, including selling vacation days for nontaxable benefits. Like other Sec. 125 benefits, vacation days that are purchased and vacation days that could have been exchanged for benefit credits (even if none of the time is sold) are provided on a use-it-or-lose-it basis and will be forfeited if not taken during the plan year.
A cafeteria plan may also allow employees to elect to purchase taxable benefits with after-tax dollars. In some instances, particular employees may prefer to purchase a nontaxable benefit, such as disability insurance, with after-tax dollars to change the tax status of the benefits when received. For example, disability benefits purchased with pretax dollars are subject to income tax when received, but are tax-free if purchased with after-tax dollars. A plan may offer the disability benefits in either form and allow employees to elect which type they want. Accident and health coverage for someone other than the employee's spouse or dependents (such as a domestic partner) may be purchased with after-tax employee contributions.
Cafeteria plans may not provide the following benefits:
• Archer 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
• Meals
• Moving expenses reimbursement
• No-additional-cost services
• Transportation benefits
• Working condition benefits
• Most deferred compensation other than under a 401(k) plan
Employees must make cafeteria plan elections before the beginning of each plan year. The IRS has defined certain circumstances under which a Sec. 125 plan may allow an employee to change his or her election of health, accident, disability, group term life insurance, adoption assistance plans, and dependent care assistance plans during the year.
Note: The plan document must specifically provide for any of the permitted election changes.
HIPAA elections. Health plan election changes required by special enrollment provisions of HIPAA are specifically permitted and are the only elections that may be changed retroactively. Please see the national Health Care Insurance section.
Change in cost or coverage. Election changes are allowed when there is a significant change in costs or available benefits. This provision applies to insured and self-insured health plans other than an FSA. For dependent care assistance plans, an election change is permitted if the employee changes providers, resulting in higher or lower costs.
Change in status. Covered elections may also be changed upon the occurrence of specified “change in status events.” These are changes in legal marital status; increase or decrease in the number of dependents; the employment status of the employee, spouse, or dependents satisfying or ceasing to satisfy eligibility requirements; and change in residence. Allowing these election changes is optional and is not required.
Consistency rules. An election change may be permitted only if it is consistent with the change in status. For instance, if the change in status is a divorce, the only consistent election change would be to drop coverage of the spouse or a dependent who is no longer eligible for coverage. In the case of group term life insurance and disability insurance, the IRS says it is consistent to either increase or decrease coverage following a change in marital status or if the employee, spouse, or dependent has a change in employment status.
To help employees adapt their benefits in response to the COVID-19 pandemic, Notice 2020-29 gave cafeteria plans added flexibility to allow midyear election changes, and Notice 2021–15 continued this relief through 2021. Employees may:
• Elect health coverage if they initially declined it at the start of the plan year.
• Revoke an existing election and instead choose different health coverage offered by the same employer.
• Revoke an existing election to enroll in a different employer’s coverage.
• Elect, revoke, increase, or reduce the contribution to a health or dependent care FSA.
These changes may be made only if the employer decides to permit them and only on a prospective basis. Also, an employee who revokes an election to select a different employer’s coverage (a spouse’s plan, for example) must provide an attestation that he or she is enrolled in, or immediately will enroll in, such coverage.
The CAA extended and broadened this midyear election relief for health and dependent care FSAs (see “FSAs,” above).
The IRS has stated that both an HSA and an HDHP associated with the HSA may be offered as options under a cafeteria plan (IRS Notice 2004-2) and has provided additional guidance on how the cafeteria plan rules apply to HSAs (IRS Notice 2004-50). Please see the national Defined Contribution Health Plans section.
Midyear election changes. Because the eligibility requirements and contribution limits for HSAs are determined on a month-by-month basis rather than annually, an employee who elects to make HSA contributions under a cafeteria plan may start or stop the election or increase or decrease the election at any time as long as the change is effective prospectively. If an employer places additional restrictions on the election of HSA contributions under a cafeteria plan, the same restrictions must apply to all employees. An employer may permit employees to elect an HSA midyear if offered as a new benefit under the employer’s cafeteria plan if the election for the HSA is made on a prospective basis. However, such an HSA election does not permit a change or revocation of any other coverage under the cafeteria plan unless the change is permitted under the rules governing midyear election changes described above. So, while an HSA may be offered to and elected by an employee midyear, the employee may have other coverage under the cafeteria plan that cannot be changed (e.g., coverage under a health FSA), which may prevent the employee from being eligible for HSA coverage.
Accelerated contributions. If an employee elects to make contributions to an HSA through the employer’s cafeteria plan, the employer may, but is not required to, contribute amounts to an employee’s HSA up to the maximum amount elected by the employee, to cover expenses that exceed the employee’s current HSA balance. While any accelerated contribution made by the employer must be equally available to all participating employees throughout the plan year and must be provided to all participating employees on the same terms, the employee must repay the amount of the accelerated contribution by the end of the plan year.
Comparability requirements. Employers can avoid the so-called comparability requirements for HSA contributions by providing the contributions through a cafeteria plan. Employers are generally required to make available comparable contributions to HSAs of all comparable participating employees for each coverage period during a calendar year. Comparable contributions are contributions that are the same amount or the same percentage of the annual deductible limit under the HDHP covering the employees. Comparable participating employees are employees who are covered under any HDHP of the employer and who have the same category of coverage (that is, self-only or family coverage). Please see the national Defined Contribution Health Plans section.
Employer matching contributions to an HSA are not subject to the comparability rule if made through a cafeteria plan, the IRS has stated. However, contributions, including matching contributions, to an HSA made under a cafeteria plan are subject to the Section 125 nondiscrimination rules (eligibility rules, contributions and benefits tests, and key employee concentration tests).
Employer contributions to employees' HSAs that are conditioned on an employee’s participation in health assessments, disease management programs, or wellness programs do not satisfy the comparability rules unless all eligible employees elect to participate in all of the programs. However, if under an employer’s cafeteria plan, employees who participate in health assessments, disease management programs, or wellness programs receive an employer contribution to an HSA, the comparability rules do not apply. Thus, such contributions may be made without having all employees participate in the programs.
The IRS has suspended the requirement that Sec. 125 cafeteria plans file a Form 5500 and Form 5500 Schedule F. This exemption applies retroactively to all years for which the forms had not yet been filed (IRS Notice 2002-24).
Note: The separate plans that are part of a cafeteria plan and that are covered by ERISA, such as health insurance plans and health FSAs, still must file a Form 5500 unless another exemption applies. Please see the national ERISA, national Benefits Recordkeeping and Disclosures sections.
Healthcare benefits provided under a Section 125 cafeteria plan or under any other arrangement in which an employee is offered a choice between healthcare benefits and other taxable or nontaxable benefits are covered by COBRA. However, the COBRA continuation coverage requirements apply only to the type and level of coverage under the cafeteria plan or other flexible benefit arrangement that a qualified beneficiary is actually receiving when COBRA obligations take effect for that individual. The IRS has also issued rules limiting the coverage of certain health FSAs under COBRA. If a plan is covered by COBRA, coverage must be provided at the expense of the covered individual following certain “qualifying events” that would otherwise terminate coverage, such as termination of employment, divorce, death of the employee, or an individual exceeding the plan's age limit for coverage. Additional notice requirements apply to plans covered by COBRA, including notices that must be provided whenever a qualifying event occurs. Please see the national COBRA (Health Insurance Continuation) section. The following examples illustrate when COBRA applies to cafeteria plan coverage.
Example 1. Under Corporation A's cafeteria plan, employees can choose among life insurance coverage, membership in a health maintenance organization (HMO), coverage for medical expenses under an indemnity arrangement, and cash compensation. Of these available choices, the HMO and the indemnity arrangement are the arrangements providing health care. The instruments governing the HMO and indemnity arrangements indicate that they are separate group health plans. These group health plans are subject to COBRA. Corporation A does not provide any group health plan outside of the cafeteria plan. Mr. X and Ms. Y are unmarried employees. Mr. X has chosen the life insurance coverage, and Ms. Y has chosen the indemnity arrangement.
Because he was not receiving any group health benefits when he terminated employment, Mr. X does not have to be offered COBRA continuation coverage upon terminating employment, nor does he have any rights to elect coverage during subsequent open enrollment periods for active employees. However, if Ms. Y terminates employment and would lose coverage under the indemnity arrangement, she must be offered an opportunity to elect COBRA continuation coverage under that plan. If Ms. Y makes such an election and an open enrollment period for active employees occurs while she is still receiving the COBRA continuation coverage, she must be offered the opportunity to switch from the indemnity arrangement to the HMO (but not to the life insurance coverage because that does not constitute coverage provided under a group health plan).
Example 2. An employer maintains a group health plan under which all employees receive coverage paid for by the employer. Employees can elect to cover their families by paying an additional amount. The employer also maintains a cafeteria plan that has an option to pay part or all of the charge for family coverage under the group health plan. If an employee's family is receiving coverage under the group health plan when a qualifying event occurs, each of the qualified beneficiaries must be offered the opportunity to elect COBRA continuation coverage. It does not matter whether the employee was paying for coverage directly, whether the employee elected the option under the cafeteria plan to pay the entire charge for family coverage, or whether the employee paid for part of the coverage and elected the option under which the cafeteria plan pays for the remaining part of the charge.
FSAs. IRS regulations limit the application of COBRA to most FSAs. COBRA continuation coverage under the FSA need not be offered for any plan year after the plan year in which the qualifying event occurs if the FSA satisfies two conditions: The employer offers another group health plan and, for the plan year in which the qualifying event occurs, the maximum amount that the FSA could charge as a premium for a full plan year of COBRA continuation coverage equals or exceeds the maximum benefit available under the health FSA for that year. This will almost always be true.
In addition, if a third condition is satisfied, the FSA need not make COBRA continuation coverage available at all. This condition is satisfied if, as of the date of the qualifying event, the maximum benefit available to the qualified beneficiary under the FSA for the remainder of the plan year is not more than the maximum amount that the plan could require as payment for the remainder of that year to maintain coverage under the health FSA.
Example. Assume that an employee elected to have $2,400 withheld from her paycheck and deposited in her FSA ($100 withheld from each bimonthly paycheck). The employee terminates after 5 months, having contributed $1,000 to the FSA and having been reimbursed for $1,100 in medical expenses. At this point, the employee would have to pay $1,400 plus 2 percent of $1,400 for the right to obtain $1,300 worth of reimbursements. Offering COBRA in such a circumstance would be pointless, according to the IRS, and need not be done.
Also note that FSAs are not eligible for ARPA premium subsidies.
If there is no written plan document or the plan is not operated in accordance with the plan document or IRC Sec. 125 and the regulations, the plan is not a cafeteria plan and an employee's election between taxable and nontaxable benefits results in taxable income to the employee. The IRS-proposed regulations provide the following list of operational failures that negate the status of a plan as a cafeteria plan:
• Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage, or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;
• Offering benefits other than permitted taxable benefits and qualified benefits;
• Operating to defer compensation (except as specifically allowed);
• Failing to comply with the uniform coverage rule;
• Failing to comply with the use-or-lose rule;
• Allowing employees to revoke elections or make new elections, except for change in status events provided for in the plan document;
• Failing to comply with the substantiation requirements for reimbursable expenses;
• Paying or reimbursing FSA expenses other than expressly permitted expenses;
• Allocating experience gains other than as expressly permitted;
• Failing to comply with the grace-period rules; and
• Failing to comply with the qualified HSA distribution rules.
Last updated on July 19, 2021.
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Section 125 of the IRC allows employees to pay for a variety of benefits with pretax dollars, thus reducing the amount of their wages that are subject to federal income and employment taxes. Employers also get a tax savings because their share of employment taxes is also reduced. The "qualified" benefits that may be provided through Section 125, or flex or cafeteria, plans include health insurance, disability insurance, group term life insurance, group legal services coverage, elective contributions to 401(k) plans, adoption assistance, and medical and childcare reimbursements. The Internal Revenue Service (IRS) says that both a health savings account (HSA) and a high-deductible health plan (HDHP) associated with the HSA may be offered as options under a cafeteria plan. Thus, an employee may elect to have pretax salary reductions contributed as employer contributions to an HSA and an HDHP. Certain benefits such as long-term care insurance may not be funded with pretax dollars through a 125 plan.
There are three major types of flexible benefit plans, including:
• The premium-only plan, which is the simplest and least expensive to administer;
• The childcare, adoption assistance, and medical flexible spending account (FSA); and
• The full-scale flexible benefit plan (aka cafeteria plan), which is the most complicated to operate.
An employer may adopt each or all of the flexible benefit plan types.
Warning: Flexible benefit plans involve complex tax rules and should not be implemented without consulting a tax adviser who specializes in employee benefits.
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 all participants.
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, but 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. 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.
The exclusion of coverage and reimbursements from an employee’s gross income under IRC Secs. 106 and 105(b) carried forward automatically to the definition of qualified benefits for Sec. 125 cafeteria plans, including health FSAs. 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 paid time off (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
• HSAs
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.
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 employees to convert, in any subsequent plan year, the unused PTO into any other benefit.
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 plan)
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 relate. 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
• Meals
• 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, a 5 percent shareholder, or an employee whose compensation exceeds the IRC Sec. 414(q)(1)(B) amount (currently $130,000) 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 HCPs, to HCIs, 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.
A POP allows employees to have their share of group insurance premiums (for employee and dependent coverage) deducted from their paychecks on a pretax basis. A typical moderately paid employee's federal income taxes and Social Security (Federal Insurance Contributions Act (FICA)) taxes will be reduced by almost 23 percent of the amount applied toward the premium. Employees in higher tax brackets will save even more. State income taxes will also be reduced. The employer's share of FICA, unemployment compensation (Federal Unemployment Tax Act (FUTA)) taxes, and sometimes workers' compensation premiums is also reduced. Employers will save between 8 percent and 10 percent of the amount by which the employees' salary is reduced to pay a group insurance premium. This savings will usually more than pay for the cost of starting up and administering the plan.
FSAs allow employees to pay for healthcare expenses, childcare bills, or adoption costs with pretax dollars by choosing an amount at the beginning of the plan year to be withheld from wages during the course of the year and deposited into a separate account. The employee is reimbursed out of the account for qualifying medical/dental or childcare expenses incurred during that year. The tax savings to both employees and the employer under an FSA are similar to those provided by a POP.
This type of setup is somewhat more complicated to administer than a POP and is often combined with a POP as a single plan. In addition to start-up costs, ongoing administration will include the cost of keeping track of employee contributions, processing and paying reimbursement claims, annual reenrollment (including communication materials to convince employees to participate), annual reports, changing reimbursement amounts during the year when permitted, and the addition of new participants.
Salary reduction contributions may be made at whatever interval the employer selects, including ratably over the plan year based on the employer’s payroll periods or in equal installments at other regular intervals (for example, quarterly installments). These intervals must apply uniformly to all participants.
Only expenses for qualified benefits incurred after the later of the effective date or the adoption date of an FSA may be reimbursed under the FSA. Similarly, if a plan amendment adds a new qualified benefit, only expenses incurred after the later of the effective date or the adoption date are eligible for reimbursement. An FSA may pay or reimburse only expenses for qualified benefits incurred during a participant’s period of coverage.
After an employee incurs an expense for a qualified benefit during the coverage period, the expense must be substantiated before it may be paid or reimbursed. All expenses must be substantiated (substantiating only a limited number of total claims or not substantiating claims below a certain dollar amount does not satisfy the requirements in the proposed regulations). FSAs for dependent care assistance and adoption assistance must follow the substantiation procedures applicable to health FSAs.
In 2005, the IRS modified its long-standing rule that a reimbursable expense must have been incurred during the plan year during which the employee contributed the funds to the medical or childcare FSA (IRS Notice 2005-42). Now, employers may offer a 2-month-and-15-day grace period during which a participant who has unused contributions or benefits for a particular qualifying benefit from the just-ended plan year, and who incurs qualifying expenses for that benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that a participant may have as long as 14 months and 15 days to use benefits or contributions for a plan year before those amounts are forfeited.
Plan amendment required. An employer may adopt a grace period for current plan year (and subsequent plan years) by amending the plan document before the end of the current year.
An FSA is permitted to have a runout period designated by the employer. A "runout period" is a period after the end of the plan year (or grace period) during which a participant can submit a claim for reimbursement for a qualified benefit incurred during the plan year (or grace period). This means that a plan may provide a deadline on or after the end of the plan year (or grace period) for submitting a claim for reimbursement for the plan year. Any runout period must be provided on a uniform and consistent basis for all participants.
IRS Notice 2013-71 (located at http://www.irs.gov/pub/irs-drop/n-13-71.pdf) modifies the former “use-it-or-lose-it” rule for health FSAs, under which an employee would forfeit all contributions and benefits that remained unused by the end of the plan year (or applicable grace period).
Now, employers may permit plan participants to carry over up to $550 of their unused health FSA balances remaining at the end of a plan year. They may use that money at any time during the following year.
Employers are not required to add the carryover option, but if they decide to add it, they must amend their plans in a timely manner and make sure they meet all the conditions for offering the carryover. Employers may choose to specify a carryover amount lower than $550.
Note that an FSA plan cannot offer both the carryover option and a grace-period option. It must be one or the other (or neither).
The Consolidated Appropriations Act (CAA) of December 2020 provided many new options for allocating FSA funds.
A grace period, usually limited to 2 1/2 months after the end of a plan year, may be extended for a full year—e.g., until the end of 2021 for amounts from 2020. It is up to the plan sponsor whether to permit such an extension; a plan with a carryover feature may choose instead to allow an unlimited carryover rather than the usual $550 maximum.
In 2021, participants in a health or dependent care FSA may be allowed to change their contribution amount on a prospective basis at any time during the year, regardless of whether any of the usual criteria for a midyear election change are met. Employees who stop participating in an FSA during 2021 or 2022 may be given until the end of the year to incur medical expenses and spend down their remaining balances.
These FSA changes are subject to the plan sponsor’s discretion, and they’re not all or nothing. Employers may adopt this relief for some but not all participants, provided the nondiscrimination tests are met. Employers will want to consider their workforce’s specific needs and consult with their service providers regarding the potential administrative complications.
For example, reduced access to healthcare and childcare services may have left employees with excess funds in their FSAs, or participants may wish to adjust the amounts already elected for 2021 to reflect the new options. But employers may need to consider the effect of such relief on HSA eligibility and, in the dependent care context, certain tax reporting requirements.
IRS Notice 2021-15 provides detailed guidance on these CAA provisions, including examples of how the increased carryover would interact with the extended period for incurring claims or, in the case of dependent care FSAs, the temporary increase in the age limit from 13 to 14.
As a practical matter, being able to carry over an entire year’s amount or extend the grace period for a full year amounts to the same relief, “as both provisions allow all unused benefits remaining for plan years ending in 2020 and 2021 to be made available for the same benefit (medical care expenses or dependent care expenses) incurred in the immediately subsequent plan year,” the IRS noted. However, the two types of relief interact differently with an extended period for incurring claims.
The American Rescue Plan Act (ARPA) of March 2021 temporarily increased the allowable contribution limit for dependent care FSAs more than twofold (see “Dependent Care FSAs,” below).
The Heroes Earnings Assistance and Relief Tax Act of 2008 amended the provisions of Sec. 125 to give employees called to active duty access to the funds in a medical FSA. A medical FSA may provide for a "qualified reservist distribution" (QRD), which is a distribution of all or part of an employee's account to an employee called to active military service. Such a distribution must be:
• Made to an individual who was ordered or called to active military duty for a period in excess of 179 days or for an indefinite period; and
• Made during the period beginning on the date of such order or call to duty and ending at the close of the active duty period.
A cafeteria plan is not required to provide for a QRD. The decision of whether to allow a QRD from a health FSA is optional with the employer. A QRD may not be made before the cafeteria plan is amended to provide for a QRD from a health FSA. The proposed IRS cafeteria plan regulations, however, allow that a plan may be amended at any time on a prospective basis (Prop. IRS Reg. Sec. 1.125-1(c)). The QRD amendment must apply uniformly to all participants in the cafeteria plan.
Who may receive a QRD? An employee who is a member of a military reserve component and is ordered or called to active duty for a period of 180 days or more or for an indefinite period may request a QRD. A QRD may not be made based on an order or call to active duty of any individual other than the employee, including the spouse of the employee. After an employee requests a QRD and before the employer may distribute an amount, the employer must first receive a copy of the order or call to active duty. An employer may rely on the order or call to determine the period that the employee has been ordered or called to active duty. If the order or call specifies that the period of active duty is for 180 days or more or is indefinite, the employee is eligible for a QRD, and the employee’s eligibility is not affected if the actual period of active duty is less than 180 days or is otherwise changed. If the period specified in the order or call is less than 180 days, a QRD is not allowed. However, subsequent calls or orders that increase the total period of active duty to 180 days or more will qualify an employee for a QRD. For example, if an employee is ordered or called to active duty for 120 days, and the order or call is subsequently extended for an additional 60 days, that individual qualifies for a QRD.
Reserve components include:
• The Army National Guard of the United States,
• The Army Reserve,
• The Navy Reserve,
• The Marine Corps Reserve,
• The Air National Guard of the United States,
• The Air Force Reserve,
• The Coast Guard Reserve, and
• The Reserve Corps of the Public Health Service.
When a QRD must be requested and distributed. An employee must request a QRD on or after the date of the order or call to active duty and before the last day of the plan year (or grace period, if applicable) during which the order or call to active duty occurred. An employer must pay the QRD to the employee within a reasonable time, but not more than 60 days after the request for a QRD has been made. A QRD may not be made for a plan year ending before the order or call to active duty. In addition, a QRD may be made only on or after the effective date of amendment of the plan to provide for QRDs.
The amount available as a QRD. The cafeteria plan amendment providing for QRDs should indicate how the plan will determine an employee’s health FSA balance for purposes of making QRDs. The cafeteria plan may provide that the amount available as a QRD will be:
• The entire amount elected for the health FSA for the plan year minus health FSA reimbursements received as of the date of the QRD request;
• The amount contributed to the health FSA as of the date of the QRD request minus health FSA reimbursements received as of the date of the QRD request; or
• Some other amount (not exceeding the entire amount elected for the health FSA for the plan year minus reimbursements).
If the cafeteria plan amendment does not indicate how the plan will determine the amount available as a QRD, the amount available is the amount contributed to the health FSA as of the date of the QRD request minus health FSA reimbursements received as of that date.
QRD procedures. A cafeteria plan may specify a process for employees to request a QRD, including how many QRDs may be made for an employee during the same plan year. A plan must permit an employee to submit health FSA claims for medical expenses incurred before the date a QRD is requested and must pay or reimburse substantiated claims for those medical expenses. A plan may either permit employees to continue to submit health FSA claims for medical expenses incurred before the end of the health FSA plan year (and grace period, if applicable) or terminate an employee’s right to submit claims.
Application of cafeteria plan nondiscrimination rules. QRDs must be uniformly available to all plan participants. The QRD amounts are disregarded for purposes of the cafeteria plan nondiscrimination rules.
Taxation. A QRD is included in the gross income and wages of the employee and is subject to employment taxes. The employer must report the QRD as wages on the employee’s Form W-2 for the year in which the QRD is paid to the employee. The amount reported as wages is reduced by any amount in the health FSA representing after-tax contributions (such as Consolidated Omnibus Budget Reconciliation Act (COBRA) continuation premiums).
Annual FSA contributions are limited; the amount is adjusted periodically by the IRS. FSA contributions from all sources cannot exceed $2,750 for tax year 2021.
An expense may not be reimbursed if it is reimbursable under any other form of health insurance. Reimbursable expenses include most out-of-pocket medical and dental expenses not covered by health insurance. These include copayments, deductibles, and many items that are not covered by many insurance plans, such as eyeglasses, and travel expenses that are primarily for and necessary for obtaining medical care. IRS Publication 502, which deals with medical expenses that qualify as itemized deductions, applies in most cases to expenses eligible for reimbursement under an FSA.
Substantiation of expenses. To be eligible for reimbursement, an expense must be substantiated by submission of a receipt or through further review. If the employer is provided with information from an independent third party (such as an explanation of benefits (EOB) from an insurance company) indicating the date of the service and the employee’s responsibility for payment for that service (i.e., coinsurance payments and amounts below the plan’s deductible), the claim is fully substantiated without the need for submission of a receipt by the employee or further review (IRS Notice 2006-69).
Prohibition against self-substantiation. Self-substantiation of an expense by an employee-participant does not constitute the required substantiation. For example, a health FSA may not reimburse participants for expenses where the participants only submit information (including via Internet, intranet, facsimile, or other electronic means) describing medical expenses, the amount of the expenses, and the date of the expenses, but do not provide a statement from an independent third party (either automatically or subsequent to the transaction) verifying the expenses. If a plan’s copayment matching system relies on an employee to provide a copayment amount without independent verification of the amount, the expense has not been substantiated. If a plan pays unsubstantiated expenses, all amounts paid from the plan are included in gross income, including amounts paid for medical care whether or not substantiated.
Weight loss programs. Expenses to lose weight are reimbursable under a medical FSA if they are for a treatment for a specific disease diagnosed by a physician (such as obesity, hypertension, or heart disease). This includes fees paid for membership in a weight reduction group and attendance at periodic meetings. Membership dues in a gym, health club, or spa are not reimbursable, but separate fees charged specifically for weight loss activities are. The costs of diet food or beverages are not reimbursable expenses because the diet food and beverages substitute for what is normally consumed to satisfy nutritional needs. However, the cost of special food that exceeds the cost of a normal diet is reimbursable under an FSA if:
• The food does not satisfy normal nutritional needs;
• The food alleviates or treats an illness; and
• The need for the food is substantiated by a physician.
Note: Premiums for medical insurance coverage are not expenses eligible for reimbursement under a medical FSA.
Over-the-counter (OTC) drugs. Under the Affordable Care Act (ACA), FSA funds could not be used to reimburse the cost of OTC medications, except insulin, unless such drugs were obtained by prescription. In 2020, however, a provision of the Coronavirus Aid, Relief, and Economic Security Act repealed this restriction for expenses incurred in 2020 or later.
Expenses do not generally become eligible for reimbursement until the service that gives rise to the expense is performed, not when the plan participant is billed for or pays for the services. This creates a problem for certain kinds of services (such as orthodontic services) where advance payments are required. In a private, nonbinding ruling, the IRS stated that in this kind of situation, it may be impossible to match costs with the provision of particular services. While it may be reasonable for an employee to be reimbursed for the full amount of the up-front payment, noted the IRS, it is not unreasonable to request a breakdown of the bill and to reimburse only those expenses for which services have actually been provided.
Covered expenses must be reimbursed (up to the annual election amount) when the covered individual has submitted documentation proving the expenses. For example, an employee in a calendar plan has elected to have $600 put into a medical reimbursement account for the year, with $50 withheld from each monthly paycheck. If the employee submits receipts for a $700 medical expense in February, the plan must reimburse the employee $600 at that time.
While only medical expenses incurred during the period of coverage are eligible for reimbursement, plans may allow a 2-month-and-15-day grace period after the end of a plan year during which expenses eligible for reimbursement could be incurred and reimbursed from contributions made during the just-ended plan year.
In Notice 2020-29, the IRS temporarily loosened the grace period rules in response to COVID-19. This relief was expanded and extended by the CAA (see “Temporary COVID-19 Relief,” above).
An FSA may reimburse medical expenses through the use of a debit card or stored-value card. The same system may also be used for health reimbursement arrangements (HRAs). The IRS approved an arrangement under which each participating employee was issued a card and certified upon enrollment in the FSA and each plan year thereafter that:
• The card would only be used for eligible medical care expenses.
• Any expense paid with the card had not been already reimbursed.
• The employee would not seek reimbursement under any other plan covering health benefits.
• The certification, which was printed on the back of the card, is reaffirmed each time the card is used.
The cardholder must also agree to acquire and retain sufficient documentation for any expense paid with the card, including invoices and receipts, where appropriate. The card would be automatically canceled at termination of employment.
Reimbursement restrictions. The use of the card is limited to the maximum dollar amount available in the cardholder's FSA. The card is effective only at merchants or service providers authorized by the employer. An employer may implement this restriction by limiting the card’s use to specified merchant category codes (MCCs) relating to health care. All charges to a card, except those that are automatically substantiated, are to be treated as conditional pending review and substantiation.
Correction procedures. The plan document must include a correction procedure in the event of a nonqualifying reimbursement. The procedure may require the employee to pay back any improper payments. If this does not work, the employer may withhold the amount of the improper payment from the employee’s wages or other compensation. Lastly, the employer may reduce future reimbursements by the improper amount. If correction is unsuccessful, the employer may treat the improper payment like any other business debt.
Automatic substantiation. The IRS said in guidance that it issued in 2003, and has since revisited, that automatic substantiation of health FSA claims is permissible. This guidance includes:
• Revenue Ruling 2003-43, which allows automatic substantiation for matching copayments and recurring expenses;
• Notice 2006-69, which expanded auto-substantiation to include copayment multiples and the inventory information approval system (IIAS);
• Notice 2007-2, which provided an additional year to develop the IIAS and introduced the “90-percent Rule,” an exception to the IIAS requirements that is available to drug stores and pharmacies whose gross receipts for the most recently ended tax year are 90 percent or more from eligible medical expenses as defined by Code Section 213(d); and
• Notice 2008-104, which says that transactions at drug stores and pharmacies to which the 90-percent Rule applies can be auto-substantiated without a receipt or conditionally approved before a receipt is provided.
Medical expenses may be auto-substantiated if incurred at physicians, dentists, vision care offices, hospitals, other qualified medical care providers, and at stores with the MCC assigned to drug stores and pharmacies and to which the 90-percent Rule applies.
The IRS pointed out in Information Letter 2018-0032 the importance of the MCC. A participant tried to use the debit card at a facility that did not have an MCC. As a result, the transaction was denied, even though the expenditure apparently was for medical care.
HRAs are a form of employer-provided medical coverage in which employers fund an account that employees may use to pay medical expenses up to a fixed amount per coverage period (usually a year). The account is generally coupled with high deductible insurance coverage. HRAs are intended to encourage employees to budget their routine medical expenses by allowing unused amounts in their account to be rolled over for potential use in the future. Please see the national Defined Contribution Health Plans section. Because medical care expenses may not be reimbursed from a Sec. 125 health FSA if they are reimbursable under any other health plan, it would appear impractical to have both an FSA and an HRA. The IRS, however, has approved a workaround for this problem if the HRA plan document is amended (before the FSA plan year begins) to specify that coverage under the HRA is available only after expenses exceeding the FSA dollar limit have been paid. Thus, the FSA funds can be used first before the HRA has to be tapped, maximizing the amount of the HRA funds that are rolled over for future use.
The Department of Health and Human Services has stated that, to the extent that a medical FSA meets the definition of an employee welfare benefit plan under the Employee Retirement Income Security Act (ERISA) and pays for medical care, it is a group health plan and is covered by the HIPAA administrative simplification requirements, including the privacy requirements. A plan that has fewer than 50 participants and is self-administered is exempt. Using an FSA debit or credit card to pay for a participant's or beneficiary's out-of-pocket medical expenses at a pharmacy or provider's office is comparable to a transaction between a participant or beneficiary and a provider, not between a health plan (the FSA) and a provider. Therefore, the transaction is not considered to be subject to HIPAA's electronic data interchange requirements. Please see the national Health Information Privacy section.
Under IRC Section 129, employees can exclude from their income certain employer-provided benefits for dependent care assistance, and Section 45(F) lets employers take a tax credit for offering childcare assistance benefits to their employees.
Under a dependent care FSA or other Section 129-qualified dependent care assistance plan (DCAP), only employment-related dependent care expenses qualify for reimbursement. The amount of employer-provided benefits that may be excluded is limited to $5,000 (or $2,500 for a married employee filing separately), though it was temporarily increased in response to the COVID-19 pandemic (see below).
The availability of this income tax exclusion is further limited to the lesser of two amounts: (1) the employee’s earned income; or (2) if the employee is married at the end of the calendar year, the earned income of either the employee or the spouse, whichever is less. This rule eliminates the use of the tax exclusion when one spouse is not employed. Special rules apply, however, in the case of spouses who are full-time students or are incapable of caring for themselves.
Employees who obtain dependent care services for a limited amount of time—that is, a period shorter than an employer’s plan year—cannot enroll in a DCAP for only the portion of the plan year for which they will need services. An employee can obtain the services of a qualified childcare provider for any amount of time they wish, but that employee can only enter into a dependent care FSA if qualifying services will be rendered for the entire period covered by the plan year.
During 2021, ARPA allows deferrals of up to $10,500 instead of the usual $5,000 (for married taxpayers filing separately, the maximum is $5,250 instead of $2,500). Employers choosing to adopt the higher limits in their cafeteria plan have until the end of the plan year to amend the plan accordingly, provided they operate consistently with the amendment in the meantime.
IRS Notice 2021-26 provided guidance on the effect of ARPA and the CAA. Dependent care benefits that would have been excluded from income if used during a given taxable year (that is, 2020 or 2021, as applicable) will remain excludable from gross income if used in the following year (2021 or 2022) due to either a carryover or a grace period. Also, these benefits will not be taken into account when applying the Section 129 exclusion limits to other dependent care benefits available for the taxable years ending in 2021 and 2022.
However, if a cafeteria plan has a noncalendar plan year beginning in 2021 and ending in 2022, the increased exclusion amount will not apply to reimbursement of expenses incurred during the 2022 portion of the plan year.
Elections are generally irreversible unless an event that may trigger a midyear election change occurs (see the discussion of Midyear Election Changes later in this section). Claims have to be reimbursed monthly, or when the total amount of the claims reaches a reasonable minimum amount. Unused amounts are forfeited at the end of the year, but a 2- to 3-month period after the end of the year is often provided for submission of claims. While only dependent care expenses incurred during the period of coverage are eligible for reimbursement, plans may provide for a 2-month-and-15-day grace period after the end of a plan year during which expenses eligible for reimbursement could be incurred and reimbursed from contributions made during the already ended plan year.
An expense is incurred when the service is performed, not when it is billed or paid for. Unlike medical expense reimbursements, the amount of a dependent care reimbursement may be limited to the amount in the employee's account when the claim is made. Ex-employees may be reimbursed for qualified expenses incurred after termination of employment but during the coverage period. In addition, a plan may provide for the reimbursement of a terminated employee’s qualified dependent care expenses incurred after termination, if all IRC Sec. 129 requirements are otherwise satisfied.
Since the exclusion under Section 129 does not cover all dependent care expenses, an employee’s claim for benefits must be verified as an eligible expense before that employee is reimbursed. If a reimbursed expense turns out to be ineligible, the employer may be subject to income tax withholding and Social Security tax obligations regarding the reimbursement.
A reimbursement can be treated as eligible dependent care assistance only when the amount the employee paid would be considered an “employment-related” expense for household and dependent care under IRC Section 21(b)(2). To qualify under this standard, an expense must satisfy the following conditions:
1. The expense must be for the care of (or household services related to) either (a) a dependent under age 13 for whom the employee is the custodial parent and who may be claimed as an exemption on the employee’s federal income tax return, or (b) a spouse or dependent (regardless of age) who is physically or mentally incapable of caring for himself or herself.
2. A service provided outside the household to a dependent or other qualifying person is an eligible expense only if the individual spends at least 8 hours a day in the employee’s household.
3. A service provided outside the employee’s household at a dependent daycare center is an eligible expense only if the center is in compliance with all applicable licensing requirements.
4. The expense must enable the employee (and spouse, if married) to be gainfully employed or to look for gainful employment (which does not include volunteer work).
5. Payments to an employee’s child who is 18 years of age or younger, or to an individual whom the employee may claim as an exemption for federal income tax purposes, are not eligible expenses.
Married employees are generally only eligible for reimbursement if their spouse is also employed. The tax-free reimbursement may not exceed the wages of the lower-paid spouse. Usually expenses for food, clothing, and education are not considered reimbursable. But if these services are incidental to and inseparably part of the care, the full expense is reimbursable, such as the cost of a childcare program that provides both meals and education.
Regulations that the IRS issued in 2008, to implement amendments to Code Section 152, address how to determine who the custodial parent is when the parents are divorced or separated and living apart. In general, the parent with whom a child lives for the greater number of nights during the calendar year may claim the child as an exemption on his or her tax return, unless that parent releases the right to claim the child to the other parent (IRS Reg. Sec. 1.152-4).
A “dependent” under Section 152 is a qualifying child or qualifying relative. Special rules apply to parents who:
• Are divorced or legally separated under a decree of divorce or separate maintenance;
• Are separated under a written separation agreement; or
• Live apart at all times during the last 6 months of the calendar year.
For purposes of Section 152(e), a child resides for a night with a parent if the child sleeps:
• At the parent’s residence (whether or not the parent is present); or
• In the company of the parent when the child does not sleep at a parent’s residence (for example, if the parent and child are on vacation).
Under Section 152(e)(2), through a written release the custodial parent may relinquish the right to claim the child as a dependent. The noncustodial parent must attach the written declaration to his or her tax return to claim a dependency exemption. A declaration must include an unconditional statement that the custodial parent will not claim the child as a dependent for the specified years.
An employer may use a payment card program to provide benefits under a dependent care FSA (IRS Notice 2006-69). Because dependent care expenses may not be reimbursed before the services are provided, an employee using a provider that requires payment before services are performed cannot be reimbursed at the time of payment, even through the use of a payment card program.
The IRS says that an employer may nevertheless adopt the following method to provide reimbursements for dependent care expenses through a payment card program.
Step 1. At the beginning of the plan year or upon enrollment in the plan, the employee is issued a payment card with a zero balance.
Step 2. The employee pays initial expenses to the dependent care provider and substantiates the initial expenses by submitting to the employer or plan administrator a statement from the dependent care provider substantiating the dates and amounts for the services.
Step 3. As soon as the services are provided as indicated by the statement from the dependent care provider, the plan makes available through the payment card an amount equal to the lesser of (1) the previously incurred and substantiated expense or (2) the employee’s total salary reduction amount to date.
Step 4. The employee then uses the amount on the card to pay his or her next installment for future dependent care expenses. The employee pays any amount not covered by the card balance out of pocket.
Step 5. Later card transactions that have been previously approved as to the dependent care provider and time period may be treated as substantiated without further review if the later card transactions are for an amount equal to or less than the previously substantiated amount.
Step 6. The payment process recycles until the end of the year (plus the grace period).
If there is an increase to the previously substantiated amount or a change in the dependent care provider, the employee must submit a statement or receipt from the dependent care provider substantiating the new claimed expense before amounts relating to the increased amount or new provider may be added to the card.
Expenses that are reimbursed tax-free through a dependent care FSA reduce the base amount for calculating the childcare tax credit (IRC Sec. 21). Lower-income employees are more likely to be better off utilizing the tax credit, while higher-bracket employees generally do better under a dependent care FSA. IRS Publication 503 provides information about the childcare tax credit.
Adoption assistance is a qualified benefit that is excludable from gross income if elected through an adoption assistance FSA, and the adoption assistance must satisfy the requirements of IRC Sec. 137. Reimbursable expenses are those incurred for qualified adoption expenses in connection with an employee’s adoption of a child, if the amounts are paid or incurred through an adoption assistance program. Adoption assistance FSAs follow the same rules as apply to dependent care FSAs.
Qualified adoption expenses. The term "qualified adoption expenses" means reasonable and necessary adoption fees, court costs, attorneys' fees, and other expenses that are directly related to and are primarily for the legal adoption of an eligible child by the employee. Qualified expenses may not be incurred for an illegal adoption or in carrying out any surrogate parenting arrangement. Expenses for the adoption by the employee of a child of his or her spouse are not qualified expenses. There are maximum limits on adoption reimbursements that are set by IRC Sec. 137.
Eligible child. The term "eligible child" means any individual who is either less than 18 years of age or physically or mentally incapable of caring for himself or herself.
Special rules for foreign adoptions. In the case of an adoption of a child who is not a citizen or resident of the United States, any qualified adoption expense is not eligible for reimbursement until the adoption becomes final. Any expense that was paid or incurred before the plan year in which the adoption becomes final is considered to have been paid or incurred during the year when the adoption became final.
The most complicated type of flexible benefit plan provides multiple taxable and nontaxable benefit choices in combination with or in addition to a POP/FSA. This type of plan is what is usually thought of as a “cafeteria plan.” While a full cafeteria plan is relatively complicated to administer, it offers employees the most options to personalize their benefit selections. Among the nontaxable benefits that may be offered through a cafeteria plan are disability and health plans, group term life insurance, dependent care assistance, adoption assistance, and elective contributions to a 401(k) cash-or-deferred arrangement. Benefits on the menu may be paid for in several ways, including by employer-provided credits to each employee, employee pretax salary reductions that may be used to purchase nontaxable benefits, and employee after-tax dollars that may be used to purchase taxable benefits included on the menu. A full cafeteria plan may also allow employees to buy and sell the value of vacation days, including selling vacation days for nontaxable benefits. Like other Sec. 125 benefits, vacation days that are purchased and vacation days that could have been exchanged for benefit credits (even if none of the time is sold) are provided on a use-it-or-lose-it basis and will be forfeited if not taken during the plan year.
A cafeteria plan may also allow employees to elect to purchase taxable benefits with after-tax dollars. In some instances, particular employees may prefer to purchase a nontaxable benefit, such as disability insurance, with after-tax dollars to change the tax status of the benefits when received. For example, disability benefits purchased with pretax dollars are subject to income tax when received, but are tax-free if purchased with after-tax dollars. A plan may offer the disability benefits in either form and allow employees to elect which type they want. Accident and health coverage for someone other than the employee's spouse or dependents (such as a domestic partner) may be purchased with after-tax employee contributions.
Cafeteria plans may not provide the following benefits:
• Archer 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
• Meals
• Moving expenses reimbursement
• No-additional-cost services
• Transportation benefits
• Working condition benefits
• Most deferred compensation other than under a 401(k) plan
Employees must make cafeteria plan elections before the beginning of each plan year. The IRS has defined certain circumstances under which a Sec. 125 plan may allow an employee to change his or her election of health, accident, disability, group term life insurance, adoption assistance plans, and dependent care assistance plans during the year.
Note: The plan document must specifically provide for any of the permitted election changes.
HIPAA elections. Health plan election changes required by special enrollment provisions of HIPAA are specifically permitted and are the only elections that may be changed retroactively. Please see the national Health Care Insurance section.
Change in cost or coverage. Election changes are allowed when there is a significant change in costs or available benefits. This provision applies to insured and self-insured health plans other than an FSA. For dependent care assistance plans, an election change is permitted if the employee changes providers, resulting in higher or lower costs.
Change in status. Covered elections may also be changed upon the occurrence of specified “change in status events.” These are changes in legal marital status; increase or decrease in the number of dependents; the employment status of the employee, spouse, or dependents satisfying or ceasing to satisfy eligibility requirements; and change in residence. Allowing these election changes is optional and is not required.
Consistency rules. An election change may be permitted only if it is consistent with the change in status. For instance, if the change in status is a divorce, the only consistent election change would be to drop coverage of the spouse or a dependent who is no longer eligible for coverage. In the case of group term life insurance and disability insurance, the IRS says it is consistent to either increase or decrease coverage following a change in marital status or if the employee, spouse, or dependent has a change in employment status.
To help employees adapt their benefits in response to the COVID-19 pandemic, Notice 2020-29 gave cafeteria plans added flexibility to allow midyear election changes, and Notice 2021–15 continued this relief through 2021. Employees may:
• Elect health coverage if they initially declined it at the start of the plan year.
• Revoke an existing election and instead choose different health coverage offered by the same employer.
• Revoke an existing election to enroll in a different employer’s coverage.
• Elect, revoke, increase, or reduce the contribution to a health or dependent care FSA.
These changes may be made only if the employer decides to permit them and only on a prospective basis. Also, an employee who revokes an election to select a different employer’s coverage (a spouse’s plan, for example) must provide an attestation that he or she is enrolled in, or immediately will enroll in, such coverage.
The CAA extended and broadened this midyear election relief for health and dependent care FSAs (see “FSAs,” above).
The IRS has stated that both an HSA and an HDHP associated with the HSA may be offered as options under a cafeteria plan (IRS Notice 2004-2) and has provided additional guidance on how the cafeteria plan rules apply to HSAs (IRS Notice 2004-50). Please see the national Defined Contribution Health Plans section.
Midyear election changes. Because the eligibility requirements and contribution limits for HSAs are determined on a month-by-month basis rather than annually, an employee who elects to make HSA contributions under a cafeteria plan may start or stop the election or increase or decrease the election at any time as long as the change is effective prospectively. If an employer places additional restrictions on the election of HSA contributions under a cafeteria plan, the same restrictions must apply to all employees. An employer may permit employees to elect an HSA midyear if offered as a new benefit under the employer’s cafeteria plan if the election for the HSA is made on a prospective basis. However, such an HSA election does not permit a change or revocation of any other coverage under the cafeteria plan unless the change is permitted under the rules governing midyear election changes described above. So, while an HSA may be offered to and elected by an employee midyear, the employee may have other coverage under the cafeteria plan that cannot be changed (e.g., coverage under a health FSA), which may prevent the employee from being eligible for HSA coverage.
Accelerated contributions. If an employee elects to make contributions to an HSA through the employer’s cafeteria plan, the employer may, but is not required to, contribute amounts to an employee’s HSA up to the maximum amount elected by the employee, to cover expenses that exceed the employee’s current HSA balance. While any accelerated contribution made by the employer must be equally available to all participating employees throughout the plan year and must be provided to all participating employees on the same terms, the employee must repay the amount of the accelerated contribution by the end of the plan year.
Comparability requirements. Employers can avoid the so-called comparability requirements for HSA contributions by providing the contributions through a cafeteria plan. Employers are generally required to make available comparable contributions to HSAs of all comparable participating employees for each coverage period during a calendar year. Comparable contributions are contributions that are the same amount or the same percentage of the annual deductible limit under the HDHP covering the employees. Comparable participating employees are employees who are covered under any HDHP of the employer and who have the same category of coverage (that is, self-only or family coverage). Please see the national Defined Contribution Health Plans section.
Employer matching contributions to an HSA are not subject to the comparability rule if made through a cafeteria plan, the IRS has stated. However, contributions, including matching contributions, to an HSA made under a cafeteria plan are subject to the Section 125 nondiscrimination rules (eligibility rules, contributions and benefits tests, and key employee concentration tests).
Employer contributions to employees' HSAs that are conditioned on an employee’s participation in health assessments, disease management programs, or wellness programs do not satisfy the comparability rules unless all eligible employees elect to participate in all of the programs. However, if under an employer’s cafeteria plan, employees who participate in health assessments, disease management programs, or wellness programs receive an employer contribution to an HSA, the comparability rules do not apply. Thus, such contributions may be made without having all employees participate in the programs.
The IRS has suspended the requirement that Sec. 125 cafeteria plans file a Form 5500 and Form 5500 Schedule F. This exemption applies retroactively to all years for which the forms had not yet been filed (IRS Notice 2002-24).
Note: The separate plans that are part of a cafeteria plan and that are covered by ERISA, such as health insurance plans and health FSAs, still must file a Form 5500 unless another exemption applies. Please see the national ERISA, national Benefits Recordkeeping and Disclosures sections.
Healthcare benefits provided under a Section 125 cafeteria plan or under any other arrangement in which an employee is offered a choice between healthcare benefits and other taxable or nontaxable benefits are covered by COBRA. However, the COBRA continuation coverage requirements apply only to the type and level of coverage under the cafeteria plan or other flexible benefit arrangement that a qualified beneficiary is actually receiving when COBRA obligations take effect for that individual. The IRS has also issued rules limiting the coverage of certain health FSAs under COBRA. If a plan is covered by COBRA, coverage must be provided at the expense of the covered individual following certain “qualifying events” that would otherwise terminate coverage, such as termination of employment, divorce, death of the employee, or an individual exceeding the plan's age limit for coverage. Additional notice requirements apply to plans covered by COBRA, including notices that must be provided whenever a qualifying event occurs. Please see the national COBRA (Health Insurance Continuation) section. The following examples illustrate when COBRA applies to cafeteria plan coverage.
Example 1. Under Corporation A's cafeteria plan, employees can choose among life insurance coverage, membership in a health maintenance organization (HMO), coverage for medical expenses under an indemnity arrangement, and cash compensation. Of these available choices, the HMO and the indemnity arrangement are the arrangements providing health care. The instruments governing the HMO and indemnity arrangements indicate that they are separate group health plans. These group health plans are subject to COBRA. Corporation A does not provide any group health plan outside of the cafeteria plan. Mr. X and Ms. Y are unmarried employees. Mr. X has chosen the life insurance coverage, and Ms. Y has chosen the indemnity arrangement.
Because he was not receiving any group health benefits when he terminated employment, Mr. X does not have to be offered COBRA continuation coverage upon terminating employment, nor does he have any rights to elect coverage during subsequent open enrollment periods for active employees. However, if Ms. Y terminates employment and would lose coverage under the indemnity arrangement, she must be offered an opportunity to elect COBRA continuation coverage under that plan. If Ms. Y makes such an election and an open enrollment period for active employees occurs while she is still receiving the COBRA continuation coverage, she must be offered the opportunity to switch from the indemnity arrangement to the HMO (but not to the life insurance coverage because that does not constitute coverage provided under a group health plan).
Example 2. An employer maintains a group health plan under which all employees receive coverage paid for by the employer. Employees can elect to cover their families by paying an additional amount. The employer also maintains a cafeteria plan that has an option to pay part or all of the charge for family coverage under the group health plan. If an employee's family is receiving coverage under the group health plan when a qualifying event occurs, each of the qualified beneficiaries must be offered the opportunity to elect COBRA continuation coverage. It does not matter whether the employee was paying for coverage directly, whether the employee elected the option under the cafeteria plan to pay the entire charge for family coverage, or whether the employee paid for part of the coverage and elected the option under which the cafeteria plan pays for the remaining part of the charge.
FSAs. IRS regulations limit the application of COBRA to most FSAs. COBRA continuation coverage under the FSA need not be offered for any plan year after the plan year in which the qualifying event occurs if the FSA satisfies two conditions: The employer offers another group health plan and, for the plan year in which the qualifying event occurs, the maximum amount that the FSA could charge as a premium for a full plan year of COBRA continuation coverage equals or exceeds the maximum benefit available under the health FSA for that year. This will almost always be true.
In addition, if a third condition is satisfied, the FSA need not make COBRA continuation coverage available at all. This condition is satisfied if, as of the date of the qualifying event, the maximum benefit available to the qualified beneficiary under the FSA for the remainder of the plan year is not more than the maximum amount that the plan could require as payment for the remainder of that year to maintain coverage under the health FSA.
Example. Assume that an employee elected to have $2,400 withheld from her paycheck and deposited in her FSA ($100 withheld from each bimonthly paycheck). The employee terminates after 5 months, having contributed $1,000 to the FSA and having been reimbursed for $1,100 in medical expenses. At this point, the employee would have to pay $1,400 plus 2 percent of $1,400 for the right to obtain $1,300 worth of reimbursements. Offering COBRA in such a circumstance would be pointless, according to the IRS, and need not be done.
Also note that FSAs are not eligible for ARPA premium subsidies.
If there is no written plan document or the plan is not operated in accordance with the plan document or IRC Sec. 125 and the regulations, the plan is not a cafeteria plan and an employee's election between taxable and nontaxable benefits results in taxable income to the employee. The IRS-proposed regulations provide the following list of operational failures that negate the status of a plan as a cafeteria plan:
• Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage, or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;
• Offering benefits other than permitted taxable benefits and qualified benefits;
• Operating to defer compensation (except as specifically allowed);
• Failing to comply with the uniform coverage rule;
• Failing to comply with the use-or-lose rule;
• Allowing employees to revoke elections or make new elections, except for change in status events provided for in the plan document;
• Failing to comply with the substantiation requirements for reimbursable expenses;
• Paying or reimbursing FSA expenses other than expressly permitted expenses;
• Allocating experience gains other than as expressly permitted;
• Failing to comply with the grace-period rules; and
• Failing to comply with the qualified HSA distribution rules.
Last updated on July 19, 2021.
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