Long-Awaited IRS Guidance on Changes in Family Status Provides Many Answers (and a Few More Questions)

Copyright John R. Hickman, Alston & Bird, and Thomas P. McCormick, Employee Benefits Institute of America

November 10, 1997

[The authors initially prepared this document for distribution to members of the Employer's Council on Flexible Compensation (ECFC). The authors serve on the ECFC Flex Advisory Council.

ECFC is a non-profit membership association committed to the promotion of cafeteria plans, 401(k) plans and other elective compensation plans. ECFC represents Fortune 500 plan sponsors, public sector and non-profit employers, and smaller employers with over 14 million workers, as well as service providers and consultants for flex plans. For membership information, contact ECFC headquarters in Washington, DC at (202) 659-4300.]

Ever since the first set of proposed cafeteria plan regulations was published in 1984, plan sponsors and administrators have struggled to determine which events qualify as a change in family status and what cafeteria plan election changes may be permissible in connection with such events. On Friday, November 7, 1997, the IRS published long-awaited change in family status guidance in the form of temporary and proposed regulations. 62 FR 60165 and 62 FR 60196. These regulations clarify which events constitute a change in family status and, for the first time, provide a roadmap for determining what changes may be consistent with the family status event. While this guidance is generally helpful, plan administrators may have less leeway in allowing election changes (outside of the parameters set forth in the new regulations) once the new regulations become effective. The highlights of the new regulations are summarized below.

I. Effective Date

The new regulations are generally effective for plan years beginning after December 31, 1998. Thus, plans have over a year to ensure compliance with the new rules. In the interim, reliance on either the new or the existing regulations is permitted.

II. Scope of the Changes

A. For Benefits Other Than Accident, Health, and Group Term Life, The Old Change in Family Status Rules Apply

The new regulations keep the existing change in family status rules for qualified benefits other than group term life insurance and accident and health coverage. Given the expansive definition of accident and health coverage contained in Section 106 of the Code (and Prop. Treas. Reg. § 1.125-2 Q&A-4)(defined to include health benefits, LTD coverage, and AD&D benefits), the new rules will apply to all qualified benefits other than dependent care assistance benefits, adoption assistance benefits and (perhaps) vacation benefits. Health and dental benefits, Health FSAs, and apparently disability and AD&D coverage, fall under the new rules.

B. Rules Pertaining to Other Events That Permit Mid-Year Election Changes Remain In Force

The current rules allowing election changes for the following events remain substantially unchanged: i) a significant change in the cost (or coverage) under a health plan provided by an independent, third party provider (current Prop. Treas. Reg. § 1.125-2 Q&A-6(b)); ii) leave of absence under the Family and Medical Leave Act (FMLA)(current Prop. Treas. Reg. § 1.125-3); iii) a revocation of election following a cessation of contributions (current Prop. Treas. Reg. § 1.125-2 Q&A-6(e)); iv) a significant change in the health coverage of the employee or spouse attributable to the spouse's employment (current Prop. Treas. Reg. § 1.125-2 Q&A-6(c)); and v) changes to the amount of elective deferrals or employee contributions under a Section 401(k) or 401(m) plan (current Prop. Treas. Reg. § 1.125-2 Q&A-6(f) restated as Treas. Reg. § 1.125-4T(j)). The new regulations note that future guidance on these issues will be forthcoming.

III. Highlights of New Rules For Accident, Health, and Group Term Life Benefits

The new rules applicable to group term life and accident or health coverage provide a two-step analysis for determining whether an employee can change his or her election during the year. First, a change in family status event must have occurred. Second, the employee's requested election change must be consistent with the event. Neither of these requirements is new. What is new is that the regulations contain six status change categories within which the event must fall. The new regulations also contain detailed guidance relating to the consistency requirement.

A. Change in Status Events

Unlike the current regulations which merely provide examples of change in family status events, the new regulations seem to provide an exhaustive list of categories of permissible events. It appears that events that do not fit within one of the enumerated categories will no longer qualify as a change in family status once the new regulations become effective. If indeed the enumerated categories are exhaustive, we are concerned that other legitimate change events have been excluded. For example, an employee who loses benefit eligibility because of a change in job classification -- salaried to hourly -- may not fall within any enumerated category. On the other hand, since the regulations use the word "including" when listing events under three of the categories -- change in marital status, number of dependents, and work schedule -- the events identified within these categories may not be exhaustive. For example, adding coverage for a new foster child who is a tax dependent under Section 152 may be permissible, even though the regulations do not mention foster children.

The new regulations provide that events falling within the following six categories are change in status events:

• Change in employee's legal marital status - including, marriage, divorce, death of spouse, legal separation, or annulment.
• Change in number of tax dependents - including birth, adoption, or placement for adoption, or death. (Note, this rule ties in with the tax definition of dependent under Section 152).
• Termination or commencement of employment by employee, spouse, or dependent.
• Change in work schedule - including reduction or increase in hours by employee, spouse, or dependent. (This provision also confirms that a strike or lockout, and commencement or return from unpaid leave would qualify).
• Dependent satisfies (or ceases to satisfy) dependent eligibility requirements - attainment of age, student status, etc.
• Change in residence or worksite of employee spouse or dependent

B. Consistency Rule

If a change in status event occurs, employees are allowed to make changes consistent with the event. The new regulations clarify (and limit) the election changes that will be consistent with the event. The consistency requirement is different for accident or health coverage versus group term life coverage.

1. Accident or Health Coverage

In order to be consistent, the change in status must result in the employee, spouse, or dependent gaining or losing eligibility for accident or health coverage (or a benefit package option -- e.g., managed care or indemnity) under the cafeteria plan or under an accident or health plan of the spouse's or dependent's employer. Apparently, in the absence of a loss or gain of coverage eligibility, an employee cannot increase or decrease his level of coverage that is elected and financed under the cafeteria plan. The proposed regulations do not provide additional rules for long-term disability coverage or AD&D coverage. Thus, apparently, an employee cannot increase or decrease such coverage under a cafeteria plan in response to a family status change absent a loss or gain of coverage eligibility. For example, an employee may no longer be able to increase his disability coverage under the cafeteria plan if his spouse terminates employment even though the employee is now the sole wage earner.

The regulations also allow an employee to increase his pre-tax contributions for coverage under his current employer's plan if a COBRA (or similar state law continuation) event occurs with respect to the employee, the employee's spouse, or a dependent -- such as loss of eligibility for regular coverage due to loss of dependent status, a reduction in hours or divorce (e.g., if the employee goes from full-time to part-time, loses health coverage and elects COBRA, the employee can increase salary reductions in mid-year to pay the unsubsidized cost of COBRA coverage). The COBRA rule apparently would not apply to COBRA coverage under another employer's plan.

2. Group Term Life Coverage

For group term life insurance coverage, an increase in coverage is permitted if there is a marriage, birth, adoption or placement for adoption. A coverage decrease is only allowed if there is a divorce, annulment, legal separation, or death of a spouse or dependent.

C. Recognition That HIPAA Special Enrollment Events, Medicare/Medicaid Entitlement and Court Orders may Allow Election Changes

1. HIPAA Special Enrollment Rights

The regulations confirm that an employee may change his cafeteria plan election for health coverage to the extent required by HIPAA. An example provides that this change may be retroactive to the extent required by HIPAA -- e.g., in the event of a birth or adoption. (This is an exception to the general rule that election changes can only take effect prospectively).

2. Judgment, Decree, or Order

A judgment, decree, or order resulting from a divorce, annulment, or legal separation (including a qualified medical child support order (QMCSO)) will allow an election change to add or drop coverage consistent with the order.

3. Entitlement to Medicare or Medicaid

Medicaid and Medicare entitlement may allow an employee to make an election change to cancel coverage. Presumably a loss of such entitlement would allow another change to add employer coverage. (The Medicare rule is contrary to prior informal IRS guidance on this issue).

IV. Comments

Written comments about the regulations can be sent within the next 90 days to CC:DOM:CORP:R (REG-243025-96), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Comments can also be submitted via the Internet at http://www.irs.ustreas.gov/prod/tax_regs/comments.html.