Can a cafeteria plan be effective prior to being formally adopted by the corporation?

[Guest cstrong]

Can a cafeteria plan be effective prior to formal adoption by the corporation? For example, can a cafeteria plan be effective (i.e., the written document executed by an authorized corporate officer) as of January 1 but not formally adopted by the board until February 1? I'd appreciate any insight.

[QDROphile]

The plan must be adopted before it can become effective, but section 125 does not say how the employer must adopt. While action by the Board is conclusive, it is a matter of corporate governance, which involves agency principles.

If the officer was indeed authorized, that should suffice. But if the officer was authorized, why did the Board "formally" adopt later? What do you mean by "authorized"?

[david rigby]

The gist of this inquiry might be one or both of:

1. 125 deductions were taken in January even tho the Board did not adopt the plan until later.

2. the sponsor may want the new 125 plan to cover expenses incurred in January even tho the Board did not adopt the plan until later.

[Guest cstrong]

When I say "authorized" I mean that the individual has authority to sign on behalf of the corporation.

Do you think it makes a difference if the plan is executed? For example, what if the plan is in place as of Janaury 1 (i.e., the plan has been drafted, the corporation is operating in accordance with its terms but it hasn't been executed because there isn't a signature line) and then the board formally adopts the plan at its February 1 board meeting to be effective as of January 1. Is the plan effective as of January 1?

[QDROphile]

Those facts aren't so good.

[Guest grafals]

The plan can be adopted during the Plan Year by the board, with an effective date preceding the date of the board resolution. This is not the preferred course of action, but it is not uncommon, and it is effective on the company. The greatest problem results when you begin operation of the plan, which later is either not ratified by the board, or is significantly changed, despite your communications with employees. And, employee elections must be made PRIOR TO the plan year, so you would have to have rolled the plan out before it began operation, and still before board adoption. There are numerous instances of companies having board resolutions to start a plan for the next year, but not meeting to adopt until the end of Q1 or Q2. This shouldn't present a problem.

Moreover, a plan can actually be deemed to exist even w/out documents or employer adoption, when intent can be inferred on the part of the employer.

In order to be fully compliant, Plan documents have to be executed and the Plan adopted by the company. However, for better or worse, judicial rulings have, in the past, inferred the existence of a Plan, where the employer behaves as though one exists. Such rulings have been supported by the IRS, DOL and Tax Court. The government takes this position to benefit the employee and punish the employer, since holding that the plan doesn't exist, subjects employees to tax liability due to the "bad act" of the employer.

I say for better or worse, because on the one hand, this can save a plan that wasn't properly adopted. But, on the other hand, the IRS or the court will look to whatever notes and records the company has in existence, and impute the plan's terms from that. Pursuant to ERISA, that generally means terms most favorable to the employees.

What you could find in your worst nightmare, is that the elections of Key Employees and HCE's get disqualified, while the company gets hit with an irrevocable plan, that provides tremendous benefits for the employees and is a nightmare to document, administer or terminate.

So, technically the Plan must be properly adopted. But, unofficially, it might exist, even w/out proper adoption or even documentation. There are probably hundreds or thousands of employers operating cafeteria plans without proper documents or adoption out there. In some cases, it ends up being no big deal. In others, it can be very costly.

If you find yourself in this predicament, the best thing to do, is compile all your company's records about the administration of the plan, put them in a binder and label it "Cafeteria Plan." Then proceed to your nearest attorney with the binder, and ask them to prepare an amended and restated plan, effective as of the date the plan began to operate.

Most important, talk to ERISA counsel ASAP.

[mbozek]

It is customary for corporate officers to have authority to adopt plan documents on behalf of the corp. In any event the document can be adopted by having a corp officer sign it subject to ratification by the board at at later date. Also the 125 regs only require a written document. I dont know what the problem is where the officer has authority to sign on behalf of the corp. In my experience most corporate boards do not want to to be involved in the adoption of welfare plans and delegate authority to corp officers.

[QDROphile]

grafals:

I think your statement misrepresents the position of the IRS. The IRS will not strain to cobble together a plan document from stray pieces or infer formal adoption from vague actions that are consistent with having a plan. I also don't think the DOL gets into the picture because section 125 plans are not ERISA plans, although the medical FSA component is subject to ERISA. You are correct that the courts have been more flexible and forgiving, especially with respect to corporate governance, as noted by mbozek.

I also think "don't worry" is a bad general message. Retroactive actions are more acceptable in the retirement area because of the rules on retroactive effective dates. There are no similar rules under section 125 and people tend to get into bad habits based on retirement plan rules. Employers should respect the applicable rules.

When you play defense, you play with what you have. It is an interesting dilemma when compliance with the formalities shortly follows initiation of operations. Do you hope for the best on defense, or do you call off the first month or two and put yourself on solid ground?

[Guest cstrong]

The real issue is whether a welfare plan has to be formally adopted and what constitutes formal adoption. Is it enough to have an authorized officer execute the plan or does the board have to approve the plan? Further, are you saying that retroactive effective dates are not acceptable in the case of welfare plans?

[mbozek]

The IRS permits exclusion of benefits from taxation only for expenses incurred after the plan is adopted or established. See RR 2002-58. However the IRS does not determine what constitutes corporate action necessary to adopt or establish any plan. The employer is responsible for adopting the plan in accordance with its procedures for corporate action.

[GBurns]

A major problem might be the PD and related documents themselves. Many of the major suppliers of section 125 plans (MHM, Humana, Colonial and AFLAC for example) state in the documents that a Board Resolution adopting the plan must be signed before the effective date. Some even use an additional form Certifying the Board Resolution.

It seems questionable to have the adoption documents dated after the effective date when the documents themselves might say that it must be done prior.

What does this PD etc actually state?

[Guest grafals]

1. The IRS will not strain to cobble together a plan document from stray pieces or infer formal adoption from vague actions that are consistent with having a plan. 

2. I also don't think the DOL gets into the picture because section 125 plans are not ERISA plans, although the medical FSA component is subject to ERISA. 

3. I also think "don't worry" is a bad general message. 

Retroactive actions are more acceptable in the retirement area because of the rules on retroactive effective dates.  There are no similar rules under section 125 and people tend to get into bad habits based on retirement plan rules. 

4. Employers should respect the applicable rules.

5. When you play defense, you play with what you have.  It is an interesting dilemma when compliance with the formalities shortly follows initiation of operations.  Do you hope for the best on defense, or do you call off the first month or two and put yourself on solid ground?

QDROPHILE,

1. I speak from experience. They will. The IRS will find the existence of a Cafeteria Plan, based on operation of the plan, even without any documents at all. Without being more specific, Trust me!

2. You are correct that the PLAN itself isn't covered by ERISA. But, the benefits provided may be. If you have only a POP or DCAP, then DOL won't get involved. But, given that MOST plans include some kind of self insured benefits, the comments only address the generalities.

3. I agree that "don't worry" is a bad general message. But, it's not my message. Take a survey of small and medium sized employers and you will find hundreds or thousands who have not complied with the formalities. Many/most won't even have a document, but are just operating a group life policy as though it were a 125 plan. "Don't worry" isn't my message. Its the message sent by the IRS when they don't rigorously enforce document requirements on employers. I have yet to see an employer suffer a material loss as a result of a document failure. It might happen. But in my experience, its not the norm. So, you don't have to like the message. But don't shoot the messenger.

Also, you are right that 125 is silent as to retro action. In fact, its entirely silent as to action. Basically, if you communicate the plan to participants, administer the plan and provide the proper tax treatment, you have a plan. If you don't have a document, you have a BAD PLAN. But, anytime a board ratifies corporate action, it is hard to claim the action or ratification is ineffective, UNLESS you have some provision to the contrary in law. Consider the fact that the board can delegate its authority to act (not its duty). Retroactive adoption wouldn't be my first recommendation either. But, when someone asks if it is permissible, I think the only possible answer is to say that it is NOT IMPERMISSIBLE. Unless you have some other basis of authority to draw on.

4. I don't think I said anything to the contrary. Attorneys are all about preaching the need to respect the rules. But, we usually get called when the client didn't. So, while I agree that the rules are to be adhered to, I offer a message that all is not lost if you didn't.

5. On your last point, I respectfully disagree. Where you WILL get sideways with the IRS is when you "call off" part of a plan year and start over. If you communicate the plan to participants, then take their $, then tell them, "oops! Sorry, lets start over" you now face potential claims by the participants you have harmed. The complaints filter in to IRS, and now they are mad and have a chance to grab some headlines. Better to follow through and fix it as soon as possible, then to make a false start. (IMHO)

[mbozek]

The provisions for board approval in documents prepared by vendors does not control how a plan can be adopted by an employer. Adoption is effected by following the employer's business practice for taking corporate action and very few employers require board approval of welfare plan docs. Also the 125 regs only require a written doc not a signed document. Notice 2002-58 requires adoption of the plan before benefits paid can be excluded from the employee's income but does not state what consitutes adoption so the employer can rely on its practice for taking corporate action and the effective date.