Salary reduction

[Ken Davis]

Hello List,

I just had someone from another listserv tell me that a cafeteria plan is

not needed to avoid constructive receipt of income in the following

circumstance. The individual seems to always give good advice, but this

answer took me totally by surprise as it implies that the reimbursement

account type of cafeteria plan is unnecessary. I'd like to get some

opinions from this listserv.

""Are you saying that it is not necessary to use a cafeteria plan to avoid

constructive receipt of income when an employee has a choice between

receiving compensation in the form of cash or an otherwise tax-free fringe

benefit? For example, an employer agrees to pay for its employees

dependent care costs up to $2,000 per employee (in a program satisfying

section 129) BUT ONLY if the employee agrees to reduce his/her salary by

that amount. The employee elects to defer $2,000 at the beginning of the

year. Is the use of a cafeteria plan required to avoid constructive

receipt of $2,000 of compensation income?""

Thanks,

Ken Davis

Univ. of South Alabama

[papogi]

Unless I’m missing something, this appears to be a fundamental example of a situation requiring a 125 plan.

[GBurns]

If this was for health insurance premiums with no employee "portion" I would say that you do not need the section 125 plan, but since this is for section 129 DCAP, I really have not looked at the IRC nor looked for case law.

Ken

You seemed to have "confused" two items that really should be kept separate. You first referred to "a cafeteria plan is not needed to avoid constructive receipt of income" which usually refers to premium amounts, but later you refer to "the reimbursement account type of cafeteria plan" which usually means the FSA, DCAP send in your receipt for reimbursement type of arrangement.

I also wondered about what the benefit was to the employer, why they wanted to go to the trouble of this arrangement in the first place?

[Ken Davis]

GBurns,

I don't follow your comment about my "confusion." Isn't an FSA a type of arrangement that must satisfy the section 125 cafeteria plan rules to avoid constructive receipt of income when the employee makes the decision to reduce salary and fund the account? That's why I mentioned both together.

Regarding the benefit to the employer, I thought I described a fairly common type of FSA. Since a DCAP is something that is usually used by only a small percentage of employees, and employers are not usually inclined to add this benefit on top of salary because of the amount, the salary reduction method seems to be the method of choice for funding the benefit. Maybe you see it differently.

Ken

[Guest jfp]

1. It is not a constructive receipt issue; cr is a concept relating solely to the timing of inclusion of what would in all events be taxable income.

2. The IRS position (and probably the correct one) is that Section 125 "preempts" all other tax law principles that might otherwise apply when an individual is given a choice between cash and benefits described in Section 125.

3. Therefore, the choice between cash and 129 benefits can only be allowed on a tax-effective basis pursuant to a 125 plan, with one possible exception. The exception is that when an employee first is hired, if he/she is given that choice up front with no opportunity thereafter to EVER change his/her mind (at least no such opportunity "on paper"), it may be possible to offer the 129 benefit on a tax-free basis on the theory that there is no element of choice of the type contemplated by Section 125 of the Code.

[g8r]

I'm a little lost on this one. I don't understand jfp's first 2 points, but agree with the third one.

Here's my view of the situation. Section 129 allows an employer to provide dependent care on a tax free basis to employees. Section 125 provides that employees don't have an inclusion in income solely b/c they have a choice of cash or a permissible tax-free benefit. (Section 129 is a permissible just like health insurance so I was a little confused at the distinction GBurns made). As we all know, having a choice between your full compensation or a non-taxable benefit is a classic 125 situation. And, aside from the 3rd situation mentioned by jfp, I can't think of any reason why a cafeteria plan would NOT be needed.

Under the 3rd situation, it's really like salary negotiation. I'll hire you for X dollars. But, if you want a little less than X dollars a year, I'll provide you with additional fringe benefits. That's why jfp referred to "no paper." Employers/employees are free to contract the terms of employment. It's only when you give choices every year that you have potential problems if you don't structure it correctly (e.g., using 125).

In this 3rd situation, it would get rather difficult in testing for nondiscrimination under 129. The employer isn't providing the benefit to everyone, and if it's a one time election when first hired, I had have a tough time applying the eligibility tests by using an "availability" approach. In other words, in a 125 plan where 129 is offered, you generally pass eligibility as to nondiscrmination under 129 b/c everyone has the benefit available, regardless of whether they elect it (similar to a 401(k) plan). But, if you're locked out of the benefit after you've negotiated your employment contract, I don't think I could make that argument. It would probably be based on those who actually have the 129 benefit.