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Cafeteria plans "restart" every year?


Griswold
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I was doing a little digging on a cafeteria plan issue and I came upon this paragraph:

While cafeteria plans have much in common with their qualified retirement plan counterparts...there are significant differences. For example, failure to correct an administrative error in a qualified retirement plan could result in taxation of all future (otherwise deferred) benefits as well as a loss of exemption for trust earnings.... Cafeteria plans, on the other hand, by their very nature restart each year i.e., an administrative error should not affect prospective exclusions once correction is made.

 

This is kind of a head-scratcher from my qualified plan perspective, where an error is an error until it's fixed. Does anyone have a cite for this restarting notion?

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It is my understanding that because elections must be made every year for Section 125 plans, the correction would be in that year only as the election doesn't carry forward. There are no balances to test, only elections vs wages, and pre-tax elections are tested within the year.   And while a plan can have a very limited amount that can be carried over for FSA Medical only (or a short grace period where last year's elected $s can still be used), it is nothing like the amount that accrues in qualified retirement plans over many, many years with attached earnings. So there are no really ongoing future or deferred benefits  after the end of the current plan year (NOTE: HSAs do NOT fall under this)   So there are no trust earnings to be taxed should the Section 125 fail nondiscrimination testing.  In the end, Section 125 plans do "restart" each year.....

I know this isn't a "cite" but is a really good explanation of Section 125 and their "every year" issues: https://www.sullivan-benefits.com/wp-content/uploads/Section-125-Cafeteria-Plans-Overview.pdf

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Griswold, I think a big part of the answer is the wording of the statutory provisions, not just the fact that a retirement plan has a trust and is a taxable entity, unless it meets exemption requirements. The curse of qualified plans is that 401(a) says a plan is qualified "if" and then starts listing pages and pages of requirements that have expanded over the years, but never specifies the time period during which the various conditions must be satisfied. In the absence of Congressional guidance regarding the timing of all those "ifs," the IRS has interpreted as meaning "if [at all times and forever]." From whence, the necessity for EPCRS and its predecessors.

125(a), by contrast, just tells you that a participant doesn't have to include nontaxable benefits in his/her income on account of constructive receipt, if the requirements of 125 are met. That is by definition a time-limited requirement, since the only tax "person" with skin in the game is the employee, who has a 3-year statute of limitations.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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" ... failure to correct an administrative error in a qualified retirement plan could result in taxation of all future (otherwise deferred) benefits as well as a loss of exemption for trust earnings.... Cafeteria plans, on the other hand, by their very nature restart each year i.e., an administrative error should not affect prospective exclusions once correction is made. ..."  Does anyone have a cite for this restarting notion?

Cafeteria plan elections can include a choice between tax preferred health coverage and cash, or upon enrolling in health coverage, an election to make the contribution with pre-tax dollars or after-tax dollars.  However, cafeteria plan elections can be evergreen - remaining in place until the participant elects a change. 

Regulations were proposed 12 years ago and have yet to be finalized.

Almost all administrative errors result from failure to timely process a change in coverage - enrollment, separation, etc.   Where the administrator failed to enroll someone in coverage and failed to take the contribution, (if permitted by the insurer or the plan document where self insured) the administrator may be able to go back and enroll the individual in coverage as elected.  Where the administrator failed to remove someone from coverage, (where permitted by the insurance contract and/or the plan document), they can go back and correct the action and refund the contributions made in error.  

Because these elections (to start or stop coverage) typically impact take home pay, more often than not, the mistake is caught fairly quickly.  

The proposed regulations state, in part:  

"...  The new proposed regulations require that a cafeteria plan offer employees an election among only permitted taxable benefits (including cash) and qualified nontaxable benefits. See section 125(d)(1)(B). ...   In general, in order for a benefit to be a qualified benefit for purposes of section 125, the benefit must be excludible from employees’ gross income under a specific provision of the Code and must not defer compensation ...  Qualified benefits must be current benefits. In general, a cafeteria plan may not offer benefits that defer compensation or operate to defer compensation. Section 125(d)(2)(A). In general, benefits may not be carried over to a later plan year or used in one plan year to purchase benefits to be provided in a later plan year. ...  "

There is much more detail.  However, it should be noted that If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees’ elections between taxable and nontaxable benefits result in gross income to the employees.  Proposed Treasury Regulation 1.125-1(c)(7) includes the following as failures: 

(A) Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage or before the later of the date of adoption or effective date of a plan amendment adding a new benefit;

(B) Offering benefits other than permitted taxable benefits and qualified benefits;

(C) Operating to defer compensation (except as permitted in paragraph (o) of this section);

(D) Failing to comply with the uniform coverage rule in paragraph (d) in §1.125-5;

(E) Failing to comply with the use-or-lose rule in paragraph (c) in §1.125-5;

(F) Allowing employees to revoke elections or make new elections, except as provided in §1.125-4 and paragraph (a) in §1.125-2;

(G) Failing to comply with the substantiation requirements of §1.125-6;

(H) Paying or reimbursing expenses in an FSA other than expenses expressly permitted in paragraph (h) in §1.125-5;

(I) Allocating experience gains other than as expressly permitted in paragraph (o) in §1.125-5;

(J) Failing to comply with the grace period rules in paragraph (e) of this section; or

(K) Failing to comply with the qualified HSA distribution rules in paragraph (n) in §1.125-5.


 

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BenefitJack, I agree that the IRS's position is that in theory it could look at a poorly administered Section 125 plan, say in 2020, determine that systematic errors in administration had occurred for all open years of the employees (e.g., 2017 - 2018) and assert that all of the employees had taxable wage income to the extent of their elected "nontaxable benefits" for those open years,  even those whose transactions with the plan had not been affected by the noncompliance. But (a) unlike in the qualified plan area, I am unaware of any judicial confirmation of the validity of such an IRS position, and (b) I don't think there would be any law, regulation, or legal principle, even in theory, pursuant to which, if the employer then started operating the plan correctly, e.g. as of 1/1/2021, its employees would continue to be taxed on their elections of nontaxable benefits. They would be in a compliant cafeteria plan for that year, and so would get the benefit of 125.

That is substantially different from a qualified plan. If the above example were a qualified plan, it could never be requalified without satisfying some prong of EPCRS. I took that to be Griswold's point.

Of course, the IRS would never go after the employees in the above example, but would take a payment from the employer.

Luke Bailey

Senior Counsel

Clark Hill PLC

214-651-4572 (O) | LBailey@clarkhill.com

2600 Dallas Parkway Suite 600

Frisco, TX 75034

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