IRS Updates Cafeteria Plan Regulations

August 13, 2007

In early August, the IRS applied a fresh coat of paint to the collage of prior proposed and temporary cafeteria plan regulations and other guidance, some of which dated back to 1984. The proposed regulations take effect for plan years starting on or after January 1, 2009. Until then, employers may rely on either these proposed regulations or the previous guidance.

These rules update and organize prior benefits guidance. However, this article will focus primarily on some of the significant clarifications and changes in the regulations. They are divided into five areas related to §125 of the Internal Revenue Code:

• Qualified and nonqualified benefits (26 CFR §1.125-1)
• Elections (§1.125-2)
• FSAs (§1.125-5)
• Claims substantiation (§1.125-6)
• Nondiscrimination testing (§1.125-7)

Qualified and nonqualified benefits

Items of note include:

• At the core of cafeteria plan administration is the concept that participating employees must have the choice between taxable and nontaxable benefits. The regulations clarify that a §125 is the "exclusive means" for doing so without resulting in a taxable event.
• Former employees can pay for COBRA on a pre-tax basis through severance pay. A cafeteria plan may reimburse an employee's individual health insurance and COBRA through another employer on a pre-tax basis. An ex-spouse’s COBRA coverage is reimbursable only on a post-tax basis.
• An employer may change the plan year and have a short plan year only if it is for a "valid business purpose."
• Cafeteria plans are for employees only. This includes former employees, but excludes self-employed individuals, sole proprietors, partners, corporate directors, and two percent S corporation shareholders. Employees who also serve the employer as corporate directors or independent contractors are eligible employees. Also, if a two percent shareholder sells all stock to an unrelated party, that individual continues to be disqualified from plan participation until the start of the next plan year.
• Mandatory two-year benefit elections for dental and vision coverage are permitted as long as premiums are paid at least annually and no premiums or flex credits from the first year are applied to the second year of coverage.
• Cafeteria plan documents must be in writing and include the following content:
  • Eligibility and election rules
  • Election irrevocability requirements, except for changes of status, if allowed
  • Contribution methods
  • Maximum election amounts
  • Plan year
  • The method has changed for calculating the cost of group term life insurance in excess of $50,000. If an employer wants to incorporate the change for the 2007 tax year, it may do so.

Elections

Election rules incorporate the fact that Health Savings Account (HSA) elections may be changed or revoked on a monthly or more frequent basis as long as they are prospective. Electronic and automatic elections are now fully acceptable. New hires have a 30-day window in which to make elections that take effect as of the date of hire. Salary reductions amounts that pay for such an election must be from compensation that is not currently available when the election is made.

FSAs

The regulations reiterate many of the familiar FSA rules: uniform coverage, use-it-or-lose-it, grace periods, the FSA-to-HSA rollover rules and the requirement that expenses be incurred before being reimbursed. There are some new wrinkles:

• Dependent Care FSAs can have a spend-down feature for former employees through the end of the current plan year (and grace period, if applicable) as long as they otherwise meet the §129 eligibility requirements.
• Cafeteria plans may limit FSA participation to those who participate in the group health plan.
• How to handle orthodontia expenses has long been a confusing topic because the only guidance was a 1997 information letter that was not an official ruling. No more. Health FSAs may reimburse these expenses when paid in advance, without worrying about when the expense was incurred.
• Prior guidance gave employers two options for using FSA forfeitures: use them to defray reasonable administrative expenses or allocate them among employees on a uniform basis. A third option is now available: employers may retain the money.
• In order to be compatible with an HSA, a post-deductible Health FSA need not match the deductible of the High Deductible Health Plan (HDHP) as long as it is at least at the statutory minimum. Thus, a $1,100/$2,200 deductible Health FSA is HSA-compatible with a $1,500/$3,000 HDHP.

Claims substantiation

The regulations repeat the golden rule of FSA claims substantiation: all claims must be substantiated. They include all of the prior debit card substantiation guidance that provides scenarios for auto-substantiation, including copayment matching, recurring expenses, real-time substantiation and inventory information approval systems.

Nondiscrimination testing

The regulations do not replace existing nondiscrimination testing rules for self-insured plans (e.g., Health FSAs and Health Reimbursement Arrangements) or Dependent Care FSAs. Instead, the regulations bring more clarity to the three §125 tests: eligibility, contributions and benefits and key employee concentration.

Important terms are clearly defined. A safe harbor percentage test is provided for satisfying the eligibility test. Several examples are provided. The tests must be run at least once per year, as of the last day of the plan year.

Infinisource is reviewing what changes, if any, to make to the cafeteria plan documents we provide and other processes. If changes are necessary, we will notify affected clients and brokers. Infinisource is also determining whether to issue comments by the November 5, 2007, deadline and whether to testify at the public hearing on November 15, 2007.

A copy of the proposed regulations is available at www.infinisource.net by clicking on Benefit Laws, Regulations and Other Resources in the Benefit Resources section, and then clicking on 2007 IRS Proposed Cafeteria Plan Regs (26 CFR §1.125 et al.).