The IRS has introduced significant proposed regulations this past month on cafeteria plans under Code Sec. 125. A cafeteria plan is a written, employer-sponsored plan allowing employees to choose among cash and qualified benefits. While the IRS wants these rules to be effective immediately, it is giving warning that some portions won’t be fully effective until the end of 2008. However, it is allowing all employers to make changes to their cafeteria plans to conform to the new rules immediately.

The new regulations introduce detailed rules governing the design and operation requirements of cafeteria plans and expand guidance on existing plan rules where previous guidance had only been informal. They spell out many rules that must be followed both in revised language to formal cafeteria plan documents and in their day-to-day application.

New discrimination test

Perhaps the most significant aspect of the new regulations imposes a new nondiscrimination test that requires nondiscrimination in cafeteria plan eligibility, contributions and benefits. Discrimination in benefits has been an overlooked area, and many employers have engaged in only modest, or even no testing, since past guidance on this has been insufficient and unclear. In light of the new rules relating to nondiscrimination testing, employers who previously performed little or no testing will need to modify their practices.

Tax-free choices

The new regulations expound to employers that Code Sec. 125 is the only mechanism by which employees can be offered a choice between taxable and nontaxable benefits. Therefore, employers must be diligent in complying with the new regulations under Code Sec. 125 since qualified benefits offered by a cafeteria plan must be nontaxable under a specific provision of the Tax Code. The new rules also provide that qualified benefits offered under a cafeteria plan include, without limitation, Health Savings Accounts (HSAs), adoption assistance, COBRA premiums, health plan coverage, group term life insurance, and dependent care assistance.

The regulations also provide that a taxable benefit can include a payment for paid time-off and severance pay and property, but cannot include a distribution from a qualified retirement plan. A cafeteria plan will violate Code Sec. 125 if it offers a nonqualified benefit, such as education assistance or long-term care.

Elections

The regs consolidate and clarify the rules involving the election of cafeteria plan benefits, including rules relating to the proper timing of elections, general irrevocability of election, use of electronic media for making elections, allowance of automatic elections for employees who fail to timely make elections, elections of salary reductions for HSA contributions and the proper election period for new employees.

Health benefits

The new regs permit a cafeteria plan to be used to pay health insurance premiums and also clarify that coverage under an employer-provided accident and health plan may be considered a qualified benefit. Under the regs, a plan may provide a two and one half month grace period after the end of the year for a participant to incur certain expenses that can be reimbursed, such as health or dependent care expenses. However, when the grace period expires, unused benefits are forfeited.

FSAs

The new regs also contain rules for including flexible spending arrangements (FSAs) in a cafeteria plan. An FSA reimburses employees for expenses of certain qualified benefits, such as medical care, dependent care and adoption assistance. The new regs require that if an FSA is included in a cafeteria plan, coverage must be uniformly provided, except in the case of dependent care or adoption assistance plans. Moreover, the use-it-or-lose-it rules apply.

Employers who sponsor cafeteria plans should review their plans to ensure compliance with the new regulations. If you have questions about the new requirements, would like us to review your plan for compliance, or require other assistance in complying with the new regulations, please call our office today.

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