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Guest Article

(From the September 15, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

REMINDER: January 1, 2009 Proposed Effective Date for New Cafeteria Plan Regulations

Cafeteria plan sponsors, their administrators and advisors will want to examine the need to bring their cafeteria plans into compliance with the proposed cafeteria plan regulations by January 1, 2009. At the time it proposed the regulations, IRS withdrew the prior Prop. Treas. Reg. §§ 1.125-1 & 1.125-2, leaving the new proposals as the only existing regulatory guidance on most of the fundamental features of IRC § 125 plans. Treas. Reg. §§ 1.125-3 and -4 -- regarding the effect of the Family and Medical Leave Act on the operation of IRC § 125 cafeteria plans and permitted mid-year election changes, respectively -- remain in effect.

Proposed Regulations Published in 2007

By issuing the new proposed regulations in August 2007, IRS effectively updated the previously existing proposed regulations which dated back to 1984. The new proposed regulations are published at 72 Federal Register 43938 (August 6, 2007) & 54716 (September 26, 2007) and -- except for certain narrow exceptions -- are proposed to be effective for plan years beginning on or after January 1, 2009. Taxpayers may rely on the proposed regulations pending the issuance of final regulations.

Cafeteria Plans

A cafeteria plan allows participants to choose between taxable benefits (e.g., cash) and nontaxable qualified benefits (e.g., employer-provided accident and health plan coverage). A number of different types of plans fall within the scope of § 125, for example:

"Flex" plans, which allow participants to choose among a variety of qualified benefits;
Premium-only plans, where the only choice is between cash and pre-tax contributions to a health plan;
Medical flexible spending accounts, which reimburse out-of-pocket medical expenses;
Dependent care flexible spending accounts, which reimburse the costs of caring for employees' dependents.

Key Provisions

The key provisions of the new proposed regulations include:

Written Plan Document. The written plan document requirement is fleshed-out to require the document to include:
- a description of the benefits available to participants;
- a description of the eligibility provisions;
- an explicit prohibition against participation by individuals who are not common law employees of the plan sponsor;
- procedures for participants' elections among benefits;
- procedures for making contributions through salary reduction or nonelective contributions;
- a stated maximum contribution per employee; and
- the plan year.
Nondiscrimination Requirements. A plan can not favor highly compensated individuals with respect to eligibility, or favor highly compensated participants with respect to contributions or benefits. A key employee test also applies. The new proposed regulations clarify terms and establish a framework for performing the tests. Hopefully IRS will substantially improve the guidance on nondiscrimination testing when it issues final regulations.
Flexible Spending Accounts. Notable changes include:
- Advance Payment for Orthodontia Work. Cafeteria plans may not be used to defer compensation. However, orthodontists often request advance payment for services that will be rendered over a period that extends beyond the current plan year -- and durable medical equipment, such as wheelchairs, often have a useful life lasting beyond the year. The new proposed regulations directly address these expenses and provide that health FSAs may pay them.
- Dependent Care Expenses incurred After Termination. Dependent Care FSAs can reimburse qualified dependent care expenses incurred after termination of employment.
- Uniform Coverage Rule. Health FSAs will not violate the rule that the maximum reimbursement amount be available at all times by making reimbursements payable on a monthly basis (or shorter interval), or by establishing a "reasonable minimum amount" for reimbursements (not greater than $500).
- New Adoption Assistance FSA. The new regulations introduce a third type of FSA, for adoption assistance. Adoption assistance FSAs must satisfy the IRC § 137 requirements for adoption assistance programs (i.e., the FSA may be used only to reimburse expenses that an employer could pay on an employee's behalf on a tax-favored basis pursuant to IRC § 137).
- Experience Related Gains. A consequence of the use-or-lose rule is that FSAs may end up with a surplus at the end of a period of coverage. The new proposed regulations clarify that employers can retain these experience gains for their own use if they choose.

What Action Will Sponsors Take?

The proposed regulations establish a more detailed and rigorous standard in order for an arrangement to qualify as a cafeteria plan. The regulations caution that, unless a plan satisfies the requirements of IRC § 125 and the regulations, the plan is not a cafeteria plan. (See Preambles and §§ 1.125-1(c)(6) & (7)) Commentators have requested further clarification regarding the discrimination testing and have requested, in light of the higher compliance standard, that IRS establish a voluntary correction program and/or a de minimis rule for compliance failures. No response has yet been issued by the IRS, and no release date for the final regulations has been projected.

The regulations are not final -- and it is not known precisely how or when they will be finalized. However, in light of the fact that they constitute the only existing regulatory guidance regarding most of the fundamental features of cafeteria plans, they are proposed to be effective for plan years beginning on or after January 1, 2009, and -- like the proposed regulations they replaced -- they state that they may be relied on to comply with the requirements of IRC § 125. Plan sponsors and their legal advisors will no doubt seek to comply with the new regulations by the January 1, 2009 deadline to the extent possible.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations.

If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955.

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.