Reminder – IRS Proposed Section 125 Cafeteria Plan Changes effective January 1, 2009
New proposed regulations for Section 125 cafeteria plans are expected to become effective for benefit plans beginning on or after January
1, 2009. The regulations, proposed by the IRS on August 6, 2007, effectively replace many of the existing and previously proposed regulations for these plans. They also reflect changes in tax law that have taken effect since the prior regulations were first proposed, as well as clarify several points that were previously in effect. Though these changes are not final, employers (except for a handful of exceptions) should comply with these regulations until the IRS issues updated guidance. Notice of these changes can be found in
Internal Revenue Bulletin:
2007-39. (Internet Explorer users may need to use the scroll bar to
view the information).
It is important to note that the new proposed regulations do not change two important sets of regulations that were finalized in 2001: the rules regarding interaction of the cafeteria plan with FMLA, and the rules governing permissible cafeteria election changes (such as those involving “change in status” events).
Highlights and Summary of the Plan Changes
Qualified Benefits – In general, in order for a benefit to be qualified under Section 125, the benefit must be excludable from the employee’s gross income and must not defer compensation. The proposed regulations clarify that
only the following are qualified benefits:
- Group term life insurance on the life of an employee that does not exceed $50,000
- Accident and health plans, including FSAs
- Payment or reimbursement of an employee’s individual accident and health insurance premiums
- Premiums for COBRA continuation under the health plan of the cafeteria plan sponsor, even if the fair market value of the premiums is included in the employee’s gross income
- Premiums for COBRA continuation for an employee of the cafeteria plan sponsor under the health plan of a different employer
- AD&D coverage
- Long-term and short-term disability coverage
- Dependent care assistance benefits
- Adoption assistance benefits
- Certain plans maintained by educational organizations to fund post-retirement group life insurance
- Contributions to health savings accounts
Nonqualified Benefits – The proposed regulations also make clear specific benefits that are not qualified under Section 125:
- Scholarships
- Employer provided meals and lodging
- Educational assistance
- Fringe benefits
- Long-term care insurance, although an HRA funded through a cafeteria plan may be used to pay premiums for long-term care insurance or for long-term care services
- Contributions to Archer Medical Savings Accounts
- Group term life insurance for an employee’s spouse, child or dependent
- Elective deferrals to section 403(b) plans
Written Plan Requirements – Section 125 requires that a cafeteria plan be documented in writing and that the plan be operated in accordance with the terms of the plan. The plan must specifically describe all benefits, outline eligibility requirements and state how employer contributions may be made under the plan. The plan provisions must apply uniformly to all participants, not just key employees.
Eligibility – All participants in the plan must be employees. This includes common law and leased employees. Additionally, former employees, including laid-off and retired employees, may be eligible to participate in the plan, though the plan may not be maintained predominantly for former employees. The new proposed regulations make clear that sole proprietors, partners and directors of corporations are not employees and may not participate in a cafeteria plan.
The proposed regulations also clarify that an employee may elect benefits through the employer’s cafeteria plan on an after-tax basis for an individual who is not an employee’s spouse or dependent, such as a domestic partner.
The fair market value of the coverage must be included in the employee’s gross income.
Dependent Care and Adoption Assistance – Up to $5,000 of employer-provided assistance for amounts paid or incurred by employees for dependent care can be excluded from an employee’s gross income. Dependent Care FSAs can also reimburse qualified dependent care expenses incurred after termination of employment. The new proposed regulations also clarify that fees paid to save a spot in day care are eligible.
The regulations also introduce a third type of FSA for adoption assistance. Generally, adoption assistance FSAs are treated in the same manner as dependent care FSAs and are subject to the same “use-or-lose” provisions. The following expenses are generally considered as qualified under the new proposed guidelines:
- Reasonable and necessary adoption fees (certain restrictions apply)
- Court costs
- Attorney fees
Expenses not allowed under an Adoption Assistance FSA include:
- Money towards adoption of the child of the participant’s spouse
- Expenses reimbursed under any other employer program or by any tax credit
- Expenses paid using funds received from any federal, state or local program
Group-Term Life Insurance – The general rule under Code Section 79 is that the cost of group-term life insurance in excess of $50,000 under policies carried directly by the employer is includable in the employee’s gross income. The proposed regulations provide that the amount includable in the employee’s gross income on the excess group-term life insurance is to be determined solely on the basis of the Table I rates (Table I of
Treasury Regulations §
1.79-3(d)(2)).
Substantiation – All FSA reimbursements must be individually substantiated by a third-party independent of the employee. The proposed regulations also contain new substantiation rules relating to post-deductible and limited-purpose FSAs.
Forfeitures – As a result of the use-or-lose rule, FSAs may end up with a surplus at the end of a coverage period (also referred to as “experience gains”). These experience gains may be retained by the employer or used to defray expenses to administer the cafeteria plan. The employer may also elect to return experience gains to the employees on a reasonable and uniform basis, or use the funds to reduce required salary reduction amounts for the following plan year.
Nondiscrimination Rules – Employers are required to perform nondiscrimination testing as of the last day of each plan year. The testing takes into account all non-excludable employees and former employees who were employed on any day during the plan year. The cafeteria plan nondiscrimination rules do not replace the nondiscrimination testing requirements that may apply to a component benefit plan under the cafeteria plan, such as a group term life plan, self-funded medical plan or a dependent care assistance program.
Next Steps
Plan sponsors should review their cafeteria plan design and operations to identify any potential compliance gaps that will require attention if the proposed regulations are finalized in their current form. In particular, consideration should be given to changes that may be needed to assure satisfactory nondiscrimination test results.
These regulations are not final, and at this time it is still unknown how or when they will be finalized. Until then, plan sponsors should consult with their legal advisors and comply with the new proposed regulations by January 1, 2009. ArlenGroup can assist in evaluating and revising current cafeteria plans in light of the proposed regulations. Please contact your ArlenGroup Consultant if you have any questions.
This document is not intended to provide any legal advice or analysis. Please
consult your own legal counsel for further information on the topics discussed in this
issue of Insight.
|
