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If it's an health FSA or dependent care FSA offered through a cafeteria plan, then the answer is that more than 2% shareholder can't participate per IRC 1372. They aren't considered employees and a cafeteria plan must generally be for employees. If these are benefits offered outside of a cafeteria plan (i.e., where an employer offers these at no cost to employees and there is no cash election), then the answer is they can't participant in the health FSA but can participate in the dependent care program (per IRC 129).

It's from Regulation 1.401(m)-1. The relevant paragraph is below (I obtained this through benefitslink source materials, but it's impossible to figure out the specific subsection). The issue comes up where you refund deferrals and there is a related match on those deferrals. The resulting rate of match is a problem under 401(a)(4). You then have two options - either forfeit the related match (even if it is fully vested), or increase the rate of match for NHCEs so that it is no longer discriminatory. After this section there is an example that goes through the process. First, refund the deferrals, then correct any ACP test failure (there you can refund a match to the extent vested), and then deal with the related match problem. 4) Coordination with section 401(a)(4). A matching contribution is taken into account under section 401(a)(4) even if it is distributed, unless the distributed contribution is an excess aggregate contribution. However, the method of distributing excess aggregate contributions provided in the plan must satisfy the requirements of section 401(a)(4). This requires that after correction each level of matching contributions be currently and effectively available to a group of employees that satisfies section 410(b). See Sec. 1.401(a)(4)-4(e)(3)(iii)(G). Thus, a plan that provides the same rate of matching contributions to all employees will not meet the requirements of section 401(a)(4) if employee contributions are distributed under this paragraph (e) to highly compensated employees to the extent needed to meet the requirements of section 401(m)(2), while matching contributions attributable to employee contributions remain allocated to the highly compensated employees' accounts. See Sec. 1.411(a)-4(b)(7) for a rule that allows forfeiture of these matching contributions to avoid a violation of section 401(a)(4). See also Sec. 1.401(a)(4)-11(g)(3)(vii)(B) regarding the use of additional allocations to the accounts of nonhighly compensated employees for the purpose of correcting a discriminatory rate of matching contributions. A method of distributing excess aggregate contributions will not be considered discriminatory solely because, in accordance with the terms of the plan, unmatched employee contributions that exceed the highest rate at which employee contributions are matched are distributed before matched employee contributions, or matching contributions are distributed (or forfeited) prior to employee contributions. See Example 6 in paragraph (e)(6) of this section.

There is no safe harbor and I agree that 4.57 sounds high. To me, if the employer is trying to favor NHCEs, then the alternative definition would fly. Otherwise, why even bother attempting to exclude certain items when there can only be a de minimis difference. It seems like a lot of effort for no gain.

Thanks KJohnson!! GBurns, when paying for spousal coverage, it probably will be a "reimbursement" arrangement similar to a health FSA. The spouse is paying for the coverage through an employer (with after-tax dollars) and the employee elects to reduce pay and get reimbursed for the premiums that the spouse paid. I'm a little shocked by Harry's change of position regarding spousal insurance. The basis for saying this wasn't allowed is that a cafeteria plan has to be primarily for the benefit of employees, although others can benefit. Where family coverage is elected that's fine. But, I wonder if Harry would allow this premium to be paid if the only person covered was the spouse. Maybe his thinking is that if a spouse is covered then that will benefit the employee even though the employee isn't actually covered by the plan. Oh well.....

It's too late if you didn't give out a conditional notice prior to the beginning of the 2003 plan year. If you gave out a notice prior to the 2003 plan year telling participants that the employer "might" make the 3% nonelective safe harbor contribution, then you have until 30 days before the end of the 2003 plan year to amend the plan to provide for the contribution and you must give out another notice to participants stating that the contribution will made.

Pjb, I'm not sure another thread would help. I think we've almost solved the mystery. You raised a good point. When comparing a loan from the plan vs. a loan from a bank, it's tax neutral. When comparing any loan (bank or plan) to using money from your own savings account and paying yourself "interest", you're always better off. The reason is because with a personal account, I can't pay myself interest -- it's a contribution. If I withdraw $10,000 and determine that I'm going to pay back $10,000 plus $500 of interest (that I would have otherwise paid to either the bank or the plan), the $500 is a contribution and isn't taxed when I withdraw it. If I were to leave the money in my savings account and borrow from the bank or plan, then if my savings account earns $500 (because I didn't withdraw funds from the account), I pay taxes because it's earnings. So, any true "loan" is at a disadvantage over using money from your own savings account. But, if you need a true "loan", then it's tax neutral whether you get if from a bank or the plan. I think that sums it up (at least for me).

I absolutely agree with you that the revenue ruling doesn't address pre-tax salary deferrals. But, then again, I don't recall seeing any mention in Code Sections 79, 105, 106, 129, etc. of providing these through pre-tax salary deferrals either. And, therein lies the crux of the disagreement. The 1961 rev. rul. is just a clarification of what 105/106 permit -- just like the recent ruling for OTC drugs. All of these revolve around the issue as to what benefits can be provided to employees on a tax-free (if the employer were to provide it at no cost to an employee). Once you've determined what benefits can be provided tax-free to employees at no cost, you then look at 125 which effectively converts employee money into employer money. I also agree that what John Hickman says doesn't make it true. What I cited was from the August 2000 ECFC symposium and was just to illustrate that everyone presumes this can be done (b/c at prior conferences the issue was specifically addressed - I was there but don't have any transcripts to cite). Unfortunately, I haven't been to those conferences in quite some time so I haven't seen anything more current. You stated that the IRS has subsequently clarified the issue and I'm curious as to where that is. More current transcripts from the ECFC symposiums are on their web site, but I couldn't find any mention of this topic. I also try to keep up with the ABA (American Bar) tax section employee benefit Q&As and don't recall any change in position or clarification of the issue. But, I'll admit I could have overlooked it. That's why I would be very interested in knowing where/when this was clarified by the IRS. All I know for sure is the Treasury position that you can't reimburse individual premiums from a health FSA offered through a cafeteria plan. And, we know that doesn't make it correct either. But, I'm not arguing (at least right now) that the reg is invalid. Rather, the regulation doesn't address paying the premium outside of a health FSA but still within a cafeteria plan. One final way of looking at this that might make it easier to understand my position. Go way back...before salary reduction cafeteria plans were around. Under 125, an employee isn't taxed merely b/c he or she has a right to get cash instead of a tax-free benefit. Pursuant to the 1961 ruling, I'm a generous employer. GBurns, if you want, I'll reimburse you for individual policies that you have paid (with after-tax dollars). But, if you don't want me to pay for the policy, I'll give you $500. Do you have to pay taxes on $500 even if you don't get the cash and I reimburse you for the premium you paid? Of course, my answer is you don't owe any taxes merely because you had the choice of receiving cash. Based on your reasoning, you would have to pay taxes. I guess we can debate this 'till the cows come home. I know people are doing this (especially with respect to paying for COBRA premiums for coverage from a prior employer), and of course, that doesn't make it right. And, don't get me wrong... I'm not in favor of allowing the reimbursement of these policies. But, it's b/c of the non-tax issues.

I did find some of the more current ECFC transcripts from August 2000. The issue relates to changes in status - and the example John Hickman raises is exactly what we're referring to. Although - I'm now not sure if it's 61-142 or 61-146. The actual issue as to whether it's allowed isn't discussed because that had already been resolved with the IRS years before this. Hickman: Stepping back for a moment, back into the realm of the proposed change in status, proposed change in cost or coverage regs, I just want to give Harry a break and get Chris back in here. One arrangement that many employers offer to employees is what’s known as a premium reimbursement account. Now this is not a flexible spending arrangement but rather under Rev. Rule 61-146, an arrangement where the employee elects to have pre-tax salary reduction fund an individual health policy or an individual supplemental health policy for themselves. But its an individual policy, not an employer based policy. And the reason I give you that background, one of the change in cost of coverage provisions is that if there’s a change in the benefit package that is offered, the Employee can then modify or change their election to elect the new coverage. So the question is, in a premium reimbursement account arrangement where the employee not the employer has selected a particular insurance carrier, does the employee have the leeway to go out and change and pick up a similar supplemental plan? If they have one cancer plan can they pick up another cancer plan at will? Keller: I think our intent when we wrote the addition of the benefit package option section was that those would be employer changes and not employee motivated changes. So I think under the regulations the answer is no. The employee deciding they want something else, you can’t say that that is the addition of a benefit package option. Its only when the employer offers something additional.

Now I'm lost. And, I don't mean to beat this to death. The entire concept of salary deferral cafe plans is to have employees contribute pre-tax. Then, when the benefit is obtained, it's tax free b/c of some code section permitting the "employer" to provide the benefit tax-free to employees. It's just like deferrals to a 401(k) plan -- they become "employer" contributions for purposes of the Code. Maybe another to explain it is like this. Look at a DCAP offered through a cafeteria plan. In most plans, the employee pays the day care with after-tax dollars and gets reimbursed for the payments that have already been made. Now, using the logic in your prior message, exactly how does this work? Why would the employee pay the expense with after-tax dollars and then have a pre-tax contribution only to get reimbursed? IRC 129 only states that "employer" provided day care can be excluded from income. Individual premium payments uses the same logic. 105/106 allows an employer to provide health coverage tax-free. I'm sure you'll agree. And, Rev. Rul. 61-142 states that an "employer" can provide individual coverage. I hope you agree with that. IRC 125 is just an exception to the doctrine of constructive receipt. My pre-tax dollars end up being converted to employer provided benefits. Anything an employer can provide tax-free can generally be offered through a cafeteria plan unless specifically excluded as a permissible benefit. And that's the key....105 and 106 are permissible benefits in a cafeteria plan. Thus, Rev. Rul. 61-142 could be applied to the cafeteria plan. I reduce my pay (just like I would with a DCAP), and I get reimbursed for expenses that I've paid with after-tax dollars. Does this make more sense? I no longer belong to ECFC so I don't know if I can access the old IRS comments but I'll try. And these are really old ... it goes back to when the proposed regs were issued stating you can't pay the premiums from the health FSA but you can do it through the normal operation of a cafeteria plan.

Here's an expansion of the example that may help those who don't understand why it's tax neutral. If you think there is double taxation (at least the way everyone is using the term here) then I'll agree. But, as used in that context, there is double taxation regardless of whether the loan is taken from the plan or not!! As pointed out, that's the reason taking the loan from the plan is tax neutral (assuming it's paid off). See the changes I made to part 2 -- And, look at the end result. That's where people are getting lost. I want to buy a car for $10,000. I have two options: 1. I borrow $10,000 at 5% for five years from the plan. Now my account has an investment earning 5% (which may not be bad these days). Loan is repaid with after-tax dollars. Let's say the interest is $500. The $500 is taxed "again" at retirement. (This is why some think there is double taxation). 2. I borrow $10,000 at 5% for five years from the bank. Loan is repaid with after-tax dollars. Again, I paid $500 to the bank and I'll never see that money again. But.... here's the reason why there is no tax advantage. What happens in my account? I didn't withdraw the $10,000 to get the loan so it stayed in the plan. And, assuming it earned 5%, I now have an extra $500 in my -- and that interest will be taxed when I withdraw it. So, what's the end result at retirement? I've paid $500 of interest with after-tax dollars (either to the plan or the bank) I get a distribution of $500 in interest from the plan (and it's taxed regardless of whether the loan originated from the plan or a bank), and I have a car worth $0.

GBurns, KJohnson stated what I was presuming was a given. I absolutely agree you can't get reimbursed for a premium if it was initially paid on a pre-tax basis (either already paid by the employer w/out an inclusion in income or if a deduction was taken for it). So, let me explain how it works (in most cases). I go out and obtain a policy and pay the premiums. It's paid with after-tax dollars. Let's say it's $100 a month. I then elect to reduce my pay by $100/month through a separate "premium payment" benefit under my employer's cafeteria plan. So, I've paid the policy with after-tax dollars, reduced my pay through the cafeteria plan, and now the employer can reimburse me for this premium purusant to Rev. Rul. 61-142. The reimbursement is tax-free pursuant to Rev. Rul. 61-142. I have now paid the premium pre-tax (no double dipping) just like any other benefit under the cafeteria plan. I don't have transcripts of seminars where the IRS has clearly stated that this is permissible (try ECFC). But, the only prohibition you see on this is through a health FSA (and even there it states these rules don't prevent the payment of expenses through the ordinary operation of the plan). Put another way, 99% of the cafeteria plans allow employees to obtain health coverage on a pre-tax basis. Exactly where does it state that this coverage must be through a "group" health plan sponsored by the employer? The answer: it doesn't -- see Rev. Rul. 61-142.

Yes, it also extends the RAP.

I agree with everything Blinky the 3-eyed Fish stated. And, to answer your specific question, even though the plan has been amended for GUST, the RAP doesn't end until 9/30. Of course by the time you read this it's too late. But, you indicated that you filed and received a DL letter. The RAP actually extends 91 days past the issuance of the letter. So, you might still have time on that basis as well.

The birth of the child would be a change in status that could trigger a change in elections. However, you have to look at the plan to see whether it permits a change in elections due to a change in status. As pointed out, if the plan permits the increase in the election, then it's an increase to the health FSA. The health FSA can generally reimburse any medical expenses of the family. Thus, it doesn't matter whether the expenses are for the mother or the child. As a practical matter, some plans permit increases in the election but no decreases. With a decrease in elections, the employer would have a greater risk of loss. There's no guidance on how to handle an increase, but presumably, if the benefit is increased by say $1,000 in the last 2 months of the year, the individual would need to contribute an extra $500 a month.

Yes, if you can pass the nondiscrimination rules in IRC 125.

I agree that if the premium had already been paid on a pre-tax basis, then you can't get reimbursed for it on a pre-tax basis. That would be double dipping. However, it is possible to pay individual premiums through a cafeteria plan. It could be structured like any other benefit paid for through the cafeteria plan. An individual can elect to reduce compensation for the "individual premium benefit" and then pursuant to Rev. Rul. 61-142, the employer could either reimburse the employee (the employee would have already paid the premium with after-tax dollars) or the employer could pay the premium directly to the insurer. In either case, the employee has effectively paid for the premium through the cafeteria plan on a pre-tax basis. The reason it's allowed is because unless a benefit is specifically prohibited, a cafeteria plan can offer any benefit the employer could otherwise offer on a tax-free basis. Without going into the details, everyone will agree health coverage can be provided through a cafeteria plan, and reason is because an employer can provide it on a tax-free basis to employees (IRC 105). And, we know that individual health insurance premiums are medical expenses under 105 and Rev. Rul. 61-142 makes it clear that an employer can reimburse or pay the carrier on a tax-free basis. Thus, it's an allowable benefit under 125 and the IRS has infomally acknowledged this as long as it's strucutred as a separate benefit. An employee elects to have the indivdual policy paid pre-tax and should the employee decide to cancel the policy, there is a risk of loss b/c any amounts already contributed can't be used for any other benefits. What has always bothered me is the fact that the IRS won't allow these to be treated in the same manner as other medical expenses that can be reimbursed under a health FSA. We know a health FSA can reimburse medical expenses under 213. Look at the list of medical expenses and you'll see insurance premiums. I have no doubt that an employee can pay for individual policies through a cafeteria plan when it's structured as a separate benefit. It's the non-tax issues that concerns me.

I guess I'll add my 2 (or 3 cents). The 61 revenue ruling allows an employer to reimburse an employee for outside coverage. This is done under 105. So, an employer could just pay for the outside coverage. If an employee wants to pay for the coverage and do it through a cafeteria plan, then informally the IRS has indicated that this can be done with a separate premium payment account (i.e., the annual election is just to pay premiums and not any other medical expenses). The cafe regs seem to allow this - they just prohibit the reimbursement of premiums from a health FSA but state that you can pay premiums through the normal operation of the plan). The authority for this -- 125 generally can be used to provide any benefit that an employer could provide tax-free to exmployees unless the benefit is specifically prohibited (such as long-term care, etc.). And, the 61 reveunue ruling allows the employer to provide individual coverage on a tax-free basis. One point not worth fighting -- if insurance premiums are medical expenses under 213, why can't they be reimbursed from a health FSA? The cafe regs prohibit this but I don't think the IRS has the authority to limit benefits that are otherwise permissible. As we saw with OTC expenses, if it's allowed under 213 it's allowed under the health FSA??? (I raised this issue with the IRS many years ago and didn't really pursue it). So, let's say you set up a separate premium payment account for individual policies. The participant should be one of the people covered under the policy, otherwise you have an issue with the requirement that generally you can over cover employees. But, there are "issues" to think about before allowing. As with a 401(k), amounts paid pre-tax by the employee become employer provided benefits - for the Code but not necessarily ERISA. The concerns are whether this policy is subject to HIPAA, COBRA, ERISA, 105 nondiscrimination? HIPAA may be the deal killer. If 2 employees get the same policy and it's now employer provided b/c it's paid through a 125 plan, can coverage be denied for the 3rd employee who wants the same policy or does HIPAA nondiscrimination prevent the denial of coverage even if the person is uninsurable??? Just some food for thought.

Under the 415 regulations, if the amount is contributed more than 30 days after the due date of the tax return, then it's treated as an annual addition for the year in which it was contributed. Whether you can still allocate it based on 2001 data is unclear (at least to me) but I wouldn't do it. You'd be making a 2002 contribution that's an annual addition for 2002 but you are allocating based on compensation figures for 2001. If any employee terminated in 2001, then you'd violate 415 in 2002 b/c the person would have no compensation. Also, it's not clear how the allocation should be tested under 401(a)(4). Arguably you'd have to take the allocation and compare it to 2002 compensation and then determine whether the allocations are nondiscriminatory. The bottom line is it could get pretty ugly if you try to allocate based on 2001 data. And, I understand it could get ugly if 2001 statements went out to participants showing an allocation.

As pointed out, the notice rules still apply. The cash-out rule just provides that you can cash the person out without consent. The notice requirement gives the person 30 days to decide what to do with the cash-out distribution. Thus, after the 30 day period, if the person doesn't respond, then the plan can either cash the person out (and take out applicable withholding) or rollover the amount to an IRA (which eventually is what EGTRRA will require for amounts over $1,000).

The expense has to be related to a mental or physical defect or illness. That's why personal items aren't valid expenses (e.g., in Publication 502 a toothbrush and toothpaste aren't allowable). Using that analysis, you could certainly twist the facts and argue that almost anything goes. For feminie products, it's tough to argue that the primary purpose is to prevent the spread of disease. For condoms, there's possibly a stronger argument, but as you point out, how do you determine whether it's for birth control or for the spread of disease. These issues aren't new. Most people have just been dealing with these issues using a reasonableness standard. Fortunately, most participants don't think about submitting some of these minor expenses as medical expenses covered by the plan. I guess it's the debit/credit card concerns where much of these issues have come in.

It definitely needs to be addressed in the plan. You can clearly use the full year or just use compensation from 4/1/02. If the plan is effective 4/1/02 (thus creating a short plan year ending 12/31/02), and you want to use full year compensation, then make an election to base compensation on the calendar year ending within the plan year and don't exclude compensation prior to entry in the plan. If you base it on plan year compensation, you would only be counting compensation from 4/1 - 12/31.

I agree that you would need the same type of substantion you would obtain for any other medical expenses that aren't dr. visits, etc. For example, it would be handled the same as someone buying a battery for a hearing aid. Which raises a question I have. If any of you use credit/debit cards, are they limited to just Dr. visits? The reason I ask is because, as evidenced by my example above, OTC drugs aren't the sole problem. You have all sorts of medical expenses that can be purchased at the store (the battery above, bandaids - which are medical equipment not an OTC drug, crutches, etc.). There are no codes for those so I could easily see that debit/credit cards be limited to use in facilities that have codes. Hey... isn't EDI going to solve all the diagnostic coding problems? : ).

FormsRmylife raised something I was thinking about in reading these posts. A cafeteria plan is not subject to ERISA. Many of the underlying benefits are subject to ERISA (although a DCAP isn't). Thus, while an SPD is needed for health benefits, technically an SPD isn't needed for the cafeteria plan (the cafeteria plan doesn't actually provide welfare benefits - it's just a tax vehicle used to exclude amounts from income). I don't know if including ERISA language in a communication piece (such as a summary of a cafeteria plan) could now turn the summary into an ERISA SPD. In other words, could a participant raise the issue that the SPD seems to offer a benefit and therefore it controls over the plan document? That is an argument made under ERISA and neither the cafeteria plan nor the DECAP are subject to ERISA. It's a gray area. The point is that as indicated in the prior messages, you can easily avoid this by providing a summary of just the benefits offered through the cafeteria plan.

Assuming it's a DC plan, those are the only 2. And, the deemed 125 amendment probably won't apply to many employers. For DB plans, you just need the deemed 125 amendment.

Paul Shultz at the IRS has made it clear that he supports the extensions referred to in prior posts (1/31/04 and if you miss the deadline for adopting the plan but adopt and file by 1/31 then the sanction is $250). However, as of yesterday (Fri.) there was still a "snag." And, as he pointed out, there's no telling what will happen until it's officially announced. He had hoped it would have been released already, but we'll have to wait and see what happens.