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Guest Article

Deloitte logo

(From the May 28, 2002 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits. Hyperlinks within the article have been added by BenefitsLink.)

IRS Endorses Automatic Enrollment Cafeteria Plans


The IRS appears to have taken a liking to automatic enrollment employee benefit plans. A few years ago, IRS placed its stamp of approval on automatic enrollment 401(k), 403(b), and 457 state and local government retirement plans. Now there is a new addition to that list: Automatic enrollment cafeteria plans. Revenue Ruling 2002-27.

Effect on Employers

Significantly, Rev. Rul. 2002-27 clears the way for cafeteria plans to incorporate automatic enrollment and ongoing automatic election features without compromising the plans' tax benefits for participants. According to the revenue ruling, "section 125 permits an employee's choice to be either in the form of an affirmative election to receive qualified benefits in lieu of cash or an affirmative election to receive cash in lieu of qualified benefits." As is the case with 401(k) plans, cafeteria plan sponsors may want to consider using automatic enrollment to prevent the plan from experiencing problems with applicable nondiscrimination rules.

Summary of Rev. Rul. 2002-27

The revenue ruling is based on two fact patterns. The first involves Employer M, which maintains a calendar year cafeteria plan (the "Plan"). The Plan offers group health insurance indemnity coverage with the option for employee-only or family coverage.

Pursuant to the Plan's automatic enrollment process, each new employee (and each current employee for the first plan year the automatic enrollment process is effective) is automatically enrolled in employee-only indemnity coverage unless he/she affirmatively elects cash or family coverage. Once enrolled, the employee's salary is reduced pre-tax to pay for part of the cost of coverage.

All employees are given a notice that explains the automatic enrollment process and their rights to opt out (i.e., elect cash instead of the default group health benefit). The notice includes the salary reduction amounts for employee-only coverage and family coverage, procedures for exercising the right to decline coverage, information on the time by which an election must be made, the period for which an election will be effective, and, for current employees, information about their existing coverage. New employees receive the notice when they are hired; current employees receive the notice before the beginning of each plan year.

New employees may opt out of group health coverage at the time they are hired or "within a reasonable period ending before the compensation for the first pay period is currently available." Current employees may opt out before the beginning of the next plan year. Once an "election" is made, it carries over to the next succeeding plan year unless changed.

The second fact pattern is almost identical to the first, except employees (new and current) can choose cash only if they certify they have other health coverage. The employer (Employer N) does not otherwise request or collect health coverage information from employees as part of the enrollment process.

Automatic Enrollment and IRC Sec. 125

The basic issue raised by these fact patterns is whether a cafeteria plan can incorporate this automatic enrollment feature for group health benefits without jeopardizing the section 125 exception to the constructive receipt doctrine. Under IRC sec. 125(a), cafeteria plan participants are not required to recognize income solely because they can choose among the plan's benefits. However, for this exception to apply, the plan must (among other things) allow participants to choose among 2 or more benefits, including at least one taxable benefit-- usually cash-- and certain "qualified benefits." (Employer-provided accident or health coverage is a "qualified benefit" for IRC sec. 125 purposes.)

Most plans require employees to affirmatively elect to receive qualified benefits in lieu of cash. However, Rev. Rul. 2002-27 clarifies that IRC sec. 125 also permits cafeteria plan sponsors to use automatic enrollment-- in other words, plan sponsors can require employees to affirmatively elect cash in lieu of a default qualified benefit without causing participants to have to include salary reduction amounts in their gross incomes.

The Second Fact Pattern

Under the second fact pattern the plan does not permit employees to elect cash in lieu of coverage unless the employee has other health coverage. According to the revenue ruling, section 125 will apply to employees who can certify they have other health coverage because they have a choice between cash and employee-only group health coverage. The revenue ruling also indicates that the section 125 exception applies to employees who can't certify that they have other health coverage, but who elect family coverage instead of employee-only coverage.

But, the revenue ruling concludes section 125 will not apply to employees who are stuck with employee-only coverage because they don't have other health coverage and can't elect family coverage. The IRS's reasoning is that these employees do not have a choice between cash and employee-only group health coverage. Nonetheless the revenue ruling points out the value of this employee-only health coverage still may be excludable from these employees' incomes under IRC section 106(a). [IRC section 106(a) specifies employer-provided accident or health plan coverage generally is not included in employees' gross incomes.]

"Deemed 125 Compensation"

Another issue for these employees who have no choice but to take the employee-only coverage (and their employers) is whether the cost of this employee-only coverage counts as compensation for purposes of the IRC section 415(c) limits on annual additions to tax-qualified defined contribution plans and a variety of other plan qualification rules. In general, IRC section 415(c) limits annual additions to $40,000 or 100 percent of the participant's compensation, whichever is less. According to section 415(c)(3)(D), the term "participant's compensation" includes cafeteria plan contributions. However, employer-paid group health premiums are not treated as compensation for purposes of section 415(c)(3) unless provided through a cafeteria plan.

Because IRS is taking the position that the employees who have to accept employee-only coverage because they don't have other health coverage are not eligible for the section 125 exception, the logical conclusion is that the cost of coverage is not part of their compensation for purposes of section 415(c). However, Rev. Rul. 2002-27 holds defined contribution plans may treat these amounts as "deemed section 125 compensation" for purposes of the section 415(c) limits and other qualification requirements that use the section 415(c)(3) definition, but only if the employer does not otherwise request or collect information regarding the employee's other health coverage as part of the enrollment process for the health plan. Retirement plans will need to be amended to incorporate "deemed section 125 compensation" into their definition of compensation if they wish to take advantage of this holding.


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

If you have questions or need additional information about this article, please contact Martha Priddy Patterson (202.879.5634) or Robert B. Davis (202.879.3094).

Copyright 2002, Deloitte.


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