LRDG

Kristine, until late 90's-early 2000, IRS did not have an audit division qualified to audit Sec. 125 plans. That is no longer true. A team of sec. 125 auditiors have been assembled, trained and is, according to IRS, auditing plans. The 2 audit examples in my previous post pre-date the existence of the Sec. 125 audit division. I'm aware of 2 cases that made head lines for Sec. 125 violations and IRS penalties assessed, both pre-dated the existing Sec. 125 audit division. In one instance the plan sponsor was required to pay back taxes (payroll taxes) for all employee participants, in addition to penalties and sanctions for allowing retro-active elections, a violation of constructive receipt provision. I'm unaware of any audit activity since the Sec. 125 audit division announcement was made. It has been debated that one of the problems that exists for IRS is that Sec. 125 Regulations and guidelines were published and continue to exist in temporary form, with incomplete or some what contridictory information. While IRS makes it clear that temporary regs will be relied on for purposes of making determinations and assessing penalties for violations, it's unclear what will happen in court, in front of a judge, if a case is ever litigated.

b2kates is correct. Irrespective of Sec. 125, the 'agreement' you describe is compensation, according IRS. Employers have attempted this type of arrangement with employees, examples pre-dating the adoption of Sec. 125 to the tax code, and IRS has been clear on what defines 'compensation'. The premiums are compensation.

Incurred expenses (with respect to Sec. 125s), must be paid and services performed within the same plan year. If either date of payment or dates of service are in a prior or subsequent plan year, the expense is not eligible for reimbursement in any plan year.

Plans can be structured to include an option allowing participants to elect pre-tax Cobra premium deductions from a final pay check to fund Medical FSAs. This type of arrangement has been confirmed informally by the IRS official who authored Sec. 125, at an ECFC conference in D.C., attended by leading world wide benefit consultants and 125 administrators. ECFC (Employers Counsel for Flexible Compensation), a DC lobbying organization sponsored the annual conference and respresents several hundred benefits prefessionals, including top Benefits, Pension and Flex plan consultants, smaller regional service providers, and large multi-national corporations for the past 15+ yrs. The arrangement provides incentive for both plan sponsor (minimize adverse selection and risk shifting), and participants (pre-tax funding).

Incurred expenses (with respect to Sec. 125s), must be paid and services performed within the same plan year. If either date of payment or dates of service are in a prior or subsequent plan year, the expense is not eligible for reimbursement in any plan year. I have to agree with papogi on both issues. Publication 502 (and 503? for dependent care) should not be relied on by either plan sponsor or participants for accurate Sec. 125 plan info. They provide more accurate information for individual income tax filers. With respect to plans allowing status changes, I have encouraged clients to allow qualified changes and supported the recommendation with documented end of year reports over a number of years and hundreds of plans. Employer tax savings have always far exceeded 'excess claims'. Our plans that limit status changes have struggled with low participation, without eliminating the risk of a participant claiming more than their contribution. Any client that I would recommend limiting status changes to would be for instance, an organization/industry experiencing high employee turn-over. Not the ideal company to sponsor a Sec. 125 plan, but we take our clients as they are.

1 client received an IRS notice for $95k in penalties assesed primarily due to failure to file 5500's for 5 prior plan yrs., a period that pre-dated our administration contract. I contacted IRS officials on behalf of the client and worked out an agreement that penalties and sanctions would be reversed if 5500s' for prior years were filed retro-actively. The IRS was reasonable and accomodating, allowed the current/most recent -year-version of the forms to be used, in lie of providing the appropriate forms and instructions for prior years (pre-printed year on forms), as there had been a number of changes to the form and instructions. I 'pleaded' administrative/contractural error on the part of the prior administrator, ignorance on behalf of the client, they were unaware of the prior administrator's failed to file, or that there were filing requirement for that matter. The client as most eager to correct the 'oversight', a mis-understanding about responsibility for filing 5500s. After the forms were filed IRS waived $95k sanctions and penalties for failure to file. (BTW, the prior administrator was no longer in business.) There was an interesting situation with IRS and another client. The client was one of the top law firms in the state. My contact rep. with the client was a young attorney and partner in the firm, and the son of one of my company's board of directors. The client was in the midst of an IRS payroll audit. IRS officials conducting the audit were alarmed to see pre-tax payroll deductions for eligible premiums and FSAs. The client explained the Sec. 125 plan, provided the plan doc., did everything possible to document the plan, to no avail. I got 'the call', talked with the lead auditor, faxed copies of Sec. 125 from the federal register and provided the audit team with a link to an IRS web-site. The auditors gathered their notes, client's payroll data, and abruptly announced the conclusion of the 'site' audit, and were not heard from again.

The criteria for the DCAP 55% average benefits test is ambeigious(sp). At best, 10% of the employee population has 'qualified' dependents. Not all 10% will incur DC expenses, others will have expenses that do not qualify for a variety of reasons. The regs do allow employees under a certain age (18?) to not be considered when applying the 55% ABT, but the result is fewer NHC employees included in the test. I have encountered a few employers who established a seperate DCAP for HC employees. Because these were existing plans, I used a hold harmless/disclaimer in the event of IRS problems with this type of arrangement. I'm not aware of an easy solution, other than reducing HCE DC elections. Providing a matching contribution to NHC might improve NHC participation, but I have no clue what impact that will have. Amended returns for prior year W-2's, employee/employer taxes paid, and 5500 will have to be amended. I'm curious to hear other suggestions.

One exception to the 'employment related' DC expense restriction worth researching is an exception for a parent requiring DC services due to illness/disability in order for the working spouse/parent to maintain employment. The exception may also apply to an employee who is a single parent.

If it's income earned during the period of coverage, FSA deductions should be made from the final pay check, irrespective of the date the check is issued. Post employment/participation claims are typically honored if incured during the period of coverage, service dates no later than the date of termination.

The example in prop reg 1.125-1, Q-18, refers to a plan that operates in a manner that allows DCFSA funds to be used for other benefits or refunded without respect to forfeiture requirements. IRS issued a moriterium on Sec. 125s. The moratorium was lifted when Proposed regs under 1.125-1 were issued. Over time there have been refindments to Sec. 125 based on administrator's experiences not anticipated by IRS when Sec. 125 was written and adopted. IRC, 2002FED 7320, Sec. 125, CAFETERIA PLAN §1.125-4 Permitted election changes.— Example 5. (i) Employee A is married to Employee B and they have one child, C. Employee A’s employer, M, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child C attends X’s on site child care center at an annual cost of $3,000. Prior to the beginning of the year, A elects salary reduction contributions of $3,000 during the year to fund coverage under the dependent care FSA for up to $3,000 of reimbursements for the year. Employee A now wants to revoke A’s election of coverage under the dependent care FSA, because A has found a new child care provider. (ii) The availability of dependent care services from the new child care provider (whether the new provider is a household employee or family member of A or B or a person who is independent of A and B) is a significant change in coverage similar to a benefit package option becoming available. Because the FSA is a dependent care FSA rather than a health FSA, the coverage rules of this section apply and M’s cafeteria plan may permit A to elect to revoke A’s previous election of coverage under the dependent care FSA, and make a corresponding new election to reflect the cost of the new child care provider. Example 6. (i) Employee D is married to Employee E and they have one child, F. Employee D’s employer, N, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child F is cared for by Y, D’s household employee, who provides child care services five days a week from 9 a.m.to 6 p.m. at an annual cost in excess of $5,000. Prior to the beginning of the year, D elects salary reduction contributions of $5,000 during the year to fund coverage under the dependent care FSA for up to $5,000 of reimbursements for the year. During the year, F begins school and, as a result, Y’s regular hours of work are changed to five days a week from 3 p.m. to 6 p.m. Employee D now wants to revoke D’s election under the dependent care FSA, and make a new election under the dependent care FSA to an annual cost of $4,000 to reflect a reduced cost of child care due to Y’s reduced hours. (ii) The change in the number of hours of work performed by Y is a change in coverage. Thus, N’s cafeteria plan may permit D to reduce D’s previous election under the dependent care FSA to $4,000. Example 7. (i) Employee G is married to Employee H and they have one child, J. Employee G’s employer, O, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Child J is cared for by Z, G’s household employee, who is not a relative of G and who provides child care services at an annual cost of $4,000. Prior to the beginning of the year, G elects salary reduction contributions of $4,000 during the year to fund coverage under the dependent care FSA for up to $4,000 of reimbursements for the year. During the year, G raises Z’s salary. Employee G now wants to revoke G’s election under the dependent care FSA, and make a new election under the dependent care FSA to an annual amount of $4,500 to reflect the raise. (ii) The raise in Z’s salary is a significant increase in cost under paragraph (f)(2)(ii) of this section, and an increase in election to reflect the raise corresponds with that change in status. Thus, O’s cafeteria plan may permit G to elect to increase G’s election under the dependent care FSA. and (iv) Application to dependent care. This paragraph (f)(2) applies in the case of a dependent care assistance plan only if the cost change is imposed by a dependent care provider who is not a relative of the employee. For this purpose, a relative is an individual who is related as described in section 152(a)(1) through (8), incorporating the rules of section 152(b)(1) and (2). Example 9. (i) Employee A has one child, B. Employee A’s employer, X, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Prior to the beginning of the calendar year, A elects salary reduction contributions of $4,000 during the year to fund coverage under the dependent care FSA for up to $4,000 of reimbursements for the year. During the year, B reaches the age of 13, and A wants to cancel coverage under the dependent care FSA. (ii) When B turns 13, B ceases to satisfy the definition of qualifying individual under section 21(b)(1) of the Internal Revenue Code. Accordingly, B’s attainment of age 13 is a change in status under paragraph ©(2)(iv) of this section that affects A’s employment-related expenses as defined in section 21(b)(2). Therefore, A may make a corresponding change under X’s cafeteria plan to cancel coverage under the dependent care FSA. The events involving the moratorium is an interesting story with relevent insight to how regs. and plans have evolved, IRS response to requests from administrators and benefits lobbying organizations.

Risk Shifting as written in the IRS regs does not refer to shifting risk of loss to participants. Risk shifting only applies to a plan sponsors regulatory requirement to apply the uniform coverage rule to a medical FSA. "Uniform coverage' meaning Medical FSAs could no longer reimburse Medical FSA claims based on the available balance, but must reimburse Medical FSA claims based on participants annual elections, irrespective of available balance. Risk Shifting to the plan sponsor/employer is the consequence of the uniform coverage rule. The participants risk of forfeiting unused Medical or DC funds have not changed since the beginning of Sec. 125 plans and it's inclusion in the IRS code. The term 'Pre-funding' (not mine), with respect to FSAs can be interperted to mean that funds reimbursed from a FSA total less than the balance that has accumulated via regular payroll deductions. I have no first hand experience with FSA plans that require participants to 'pre-fund' spending accounts. I have heard of FSA plans designed by plan sponsors that require spending accounts to be 'pre-funded', but I personally am not an advocate of that type of arrangement, find it is administratively more complicated, and that in practice it serves no purpose.

Rob R, there are fundemental IRS compliance problems with statements in your reply. There is no risk shifting in a DC-FSA, (or COBRA). DC-FSA claims are only paid up to the available balance vs. Medical FSA claims which must be paid up to the annual elected amount, involving risk shifting. When making any FSA election change, the account balance, after adjustments, is reduced by prior claims. Again, it's basic accounting practices that do not violate IRS compliance. Following the example i used previously: $600 funded from January-July at $100 monthly -$300 funded from January-July at $ 50 monthly ------- $300 = the extent to which the account was overfunded, and eligible to be refunded post-tax to X, less claims previously paid. However, because DC-FSAs only reimburse up to the available balance, off-setting previously paid claims would be uncommon. After all DC-FSA adjustments are made if there's a negative balance, previously paid claims that exceed the NEW account balance would be denied as ineligible because they exceed the elected amount. The over payment, plus tax, must be paid back to the plan by the participant. The facts and circumstances outlined by cr? are that the original DC election included expenses intended to be spent later in the plan year. The election change is IRS Eligible based on facts and circumstances. For example, the dependent attends before school (7a-8a) and after school (3p-6p) day care, totaling 4hrs. per day, at $45.00 per week. During the summer months day care is, for instance 7am-6pm, 11 hrs. per day, costing $135 weekly. The day care provider decides they will not be offering summer day care services for any number of business reasons. For example, registeration for the summer DC program was lower than expected. I've seen this in school based day care programs. The original $1200 election was based on $900 summer camp expenses that for reasons beyond the control of the DC participant, will not be incured and qualifies for an election change. No risk-shifting, no COBRA.

GBurns, "I had not come across this situation before". No offence intended, but I find that hard to believe. " LRDG does cause me to think that it could be done." Seems you've given this some thought. I'm flattered that you even consider the possibility that a qualified election change coule be for an amount less than the original election amount. (Not flaming. On second thought, maybe a not-to-hostile-flame. a friendly flame, but only because I like your posts and use of reference material.) the number of similar circumstances i've encountered, researched and confirmed with bureau chief of the IRS Division of Employee Benefits and Tax Exempt Organizations. The most recent discussion with IRS about a "qualified post tax refund"? took place more than a decade ago at a Sec.125 conference in DC. The IRS official authored Sec.125. I think it is difficult to argue the issue based on my source. If my post contained professional opinion or speculation, I would indicate that it was. Pensions in Paradise, i couldn't agree with you more.

Administeration of a cafeteria plan by a TPA/Accounting firm vs. issuing a Legal Plan Document by a TPA or accounting firm is the issue. I'm not aware of any recent litigation, however it's common practice for TPA/Accounts to use a proto-type document written by their legal representatives. When the proto-type PD is issued, the TPA/Account comminicate the need for reviewe by the plan sponsor's attorney, with disclaimer that no liability is assumed until approved by an attorney. I'm not at all sure how much protection the disclaimer provides. if litigated the outcome may not be favorable to TPAs/Accountants. Not all TPAs/Accountants require an attorney to review the PD or include a disclaimer. Many plan sponsor's don't forward the PD for review even when recommended with a disclaimer, often to avoid legal fees.

jpod, this is NOT a zero balance issue. It is NOT a FORFEITURE issue. It is an accounting issue based on an eligible election change. Nothing in the IRS regs prevent FSA account adjustments and post tax participant refunds becuse of eligible election changes or administrative error, provided an amount otherwise meeting the Forfeiture requirements is not refunded. EXAMPLE: assume employee X's DC-FSA annual election was $1200 for January 1st thru December 31st plan year, with payroll deduction of $100 per month. In July X has funded/deposited $600 into hir DC-FSA. Employee X makes a qualifying annual election change reducing hir election to $300.00, funded by payroll deduction of $50 monthly beginning January 1st thru July 31st, at which time X will no longer participate. Original Election $1200, *$600 funded to X's DC-FSA based on $100 monthly from January thru July* New Election $ 300, *$300 funded to X's DC-FSA based on $ 50 monthly x 6 mos = $300.00 from January thru July*. $600 funded from January-July at $100 monthly -$300 funded from January-July at $ 50 monthly ------- $300 = the extent to which the account was overfunded, and eligible to be refunded post-tax to X.

Sorry but i disagree. The DC-FSA account balance must be adjusted based on the new election. I'm not suggesting that forfeiture can be avoided. but forfeiture is not an issue if after making payroll deduction adjustments based on the new election amount the participant's original election resulted in 'overfunding' the DC-FSA.

If the new election amount resulted in overfunding based on the original election to the DC-FSA, a post-tax refund can be made to the participant. IRS regs with respect to qualifying events allow participants to change annual elections. As with any mid-year qualifying election change, the event and the election change must be consistant. The participants plan year changes from January-December, assuming it's calander plan year. The participant's new plan year will begin in January and end on the date that coincides with the effective date of the qualifying event. It's possible for the participant to change their annual election to equal the amount reimbursed during the period of coverage and remain compliant with IRS regs.

If there is a qualifying event/status change there is an opportunity for the participant to change their annual election, which usually results in a recalculation/adjustment to the payroll deductions previously credited to the DC account balance as of the effective date of the qualifying event. Example: The annual elected amount $4000, or $333.33 per month. $1999.99 funded over 6 mos. into the DC account. If the qualifying event results in $2000 annual election, $166.66 payroll deduction over 12 mos, resulting in $999.99 funded through the date of the qualifying event that occured in the 6th month of the plan year.

I have always understood a significient change in an Employers benefit plans qualifies as a status change provided the employee election is consistant with the Benefit change. This provision expanded the former "family status change' only addressed in Sec. 125, to include for example, employer benefit plan changes, a spouses benefit changes due change in employment, a change in a dependents student status, and similar circumstances beyond the control of the employee. The provision is addressed in one of 4 temporary Sec. 125 regulations.

L is a medical FSA COBRA eligible beneficiary. but what is the advantage of participation in a medical FSA for L? If L continues to qualify as a dependent with respect to A's income tax filing status, there would be an advantage for A to make a health FSA COBRA election for L's expenses. A's Cafeteria plan COBRA election could include L's Medical Insurance Premiums, in addition to L's medical FSA expenses.

in general ERs can withhold pre-tax premiums from EEs final paycheck. The election would be consistant with COBRA, and nothing in the IRS regs/code prevents retroactive or advance payment of premiums pre-tax. the specific circumstances under which the EE will receive a paycheck in the summer and the eligibelity of retroactive pre-tax premium payment will have to be reviewed to ensure compliance.

Statutory regs require a plan impose a max contribution at the plan sponsor's discression. The max contribution should consist of pre-tax premiums, medical FSA and dependent/child care FSA. The max must be in the plan doc., in addition to materials distributed to eligible employee population. The max contribution is determined by the highest premium contribution for each benefit catagory eligible under Sec. 125. For example assume $4200 max. eligible premiums consisting of annual family medical premiums, family dental, employee life and disability income. Child care FSA max of $5000 under Sec. 129 (?) regs. The max employee contributions to the medical FSA as determined by the plan sponsor, assume $3000. The max participant contribution stated in the plan doc and employee material is $12,200.

Use the phrase 'uniform coverage' under a Medical FSA in a search engine. The best sites will reference IRS regulation.

GBurns, best short answer describing disadvantage to participating in a Cafeteria plan.

based on my experience, lower paid employees find affordable child care providers, NY to NM, irrespective of geografic locations or 'area of the country' . middle and higher income EEs with child care expenses often exceed the maximum 5k. The income of an employee population is not a selective process undertaken by an administrator. It's not personal either.