Inadvertent Cafeteria Plan?

[Alf]

If employees are given a choice at hire between different fully insured welfare benefit packages (benefits and less compensation OR no benefits and more compensation), is that a cafeteria plan? A formal cafeteria plan happens to be one of the benfits available to all employees, but new hires are allowed to choose between two employment categories, which directly affects whether they get high benefits/low cash or low benefits/high cash.

Is there any way to structure this to avoid technical questions about this being a 125 plan? Can we have employees execute a one-time irrevocable election to be one class over the other, or is there something that we are missing?

I know this is done a lot in the case of employees vs. independent contractor cases like Microsoft, but I have never heard about whether this creates an inadvertant 125 plan where the choice is between two classses of employees.

[E as in ERISA]

Okay. I see. Slightly different issue. It is a matter of negotiation at the time of employment? A person hired into category A dollars gets compensation of X + Y and zero benefits, while a person hired into category B gets compensation of X and benefits of Y? My vague recollection is that was okay. But I can't recall the source and I'm not 100% certain.

[Alf]

That is the Q. I don't know why this doesn't raise 125 plan issues, but I hope that it doesn't. Does anyone know of a way (explicit election) that we can clarify this for posterity and avoid questions about 125?

[QDROphile]

Can the employee switch classification from year to year? If the employee can effectively change from year to year, the argument that the employee has simply negotiated into a class of employees that are entitled to a different compensation package is pretty flimsy. If the employee is essentially stuck in the class, then the argument might fly, but there is still risk.

You would also want the payroll system and other employment features and labels to be consistent with and support the class system, which might not be good for the culture.

[KJohnson]

PLR 9406002 ---

In the instant case, ****prospective employees…contract to perform services under an arrangement whereby a portion of the remuneration otherwise payable for their services will be paid to a third-party (i.e., the insurance company). In our view, it is irrelevant in this situation that services have not been performed prior to entering into the contract. If a prospective employee contracts to have *** pay amounts to the insurance company where the employee has the option of receiving those amounts as wages, the employee is merely assigning future income (cash compensation) for consideration (accident and health insurance coverage) and thus, is treated as receiving the cash compensation for which the accident and health insurance coverage is a mere substitute. It is as if the entire compensation for services had been paid directly to the employee and then a portion paid over by the employee as his or her contribution to payment of the accident and health insurance premiums. Accordingly…to the extent that the employee could have otherwise received an amount that is paid to the insurance company, it is includible in the employee’s gross income at the time it is paid over to the insurance company…By enacting section 125 of the Code, Congress set forth a statutory scheme, complete with nondiscrimination requirements, under which employers could offer their employees or prospective [emphasis added] employees a choice between cash and certain excludable employer-provided benefits such as accident and health insurance. To conclude, as Taxpayer does, that a type of choice specifically authorized by section 125 is not subject to that provision because it is part of the “negotiation” of the employment contract is, in our view, contrary to the statutory language and

the intent of Congress in enacting section 125 of the Code .

[E as in ERISA]

But does that deal with the use of classifications? It is legal for an employer to provide different benefits to different classifications of employees -- e.g., part time v. full time -- and employees work just enough hours to be considered full time so that they can get health benefits. So where do you draw the line?

[KJohnson]

I think an employer can clearly provide different benefits to different classes of employees as long as any applicable 105/125 nondiscrimination rules are complied with.

However, in my mind, it all turns on employee "choice". If employees--prospective or current-- have a choice between cash or benefits, you have 125 issues. If employees don't have a choice you do not.

I suppose if an employer legiitimately had two job openings--Job X with benefits--no choice; and Job Y with no benefits--no choice; and the employee applied for both jobs and was offered both jobs, then you may be able to avoid the issue.

[Alf]

That PLR sounds brutal for us. Thanks (or no thanks, I guess) for the cite. Our proposal is going to be a little more formal and indirect in that individuals will get to choose their classification and the insured plans will exclude one of the two groups, but I assume that is how the plans in the PLR had to read. Is there a way to work this under the 125 rules by treating the one time election at time of employment as a cafeteria plan (do cafeteria plans have to allow annual elections)?

[GBurns]

You might also want to get some guidance from cases such as Express Oil Change at http://laws.findlaw.com/11th/967148opn.html

Read not only the Appeal but also the initial case. There are a few other similar cases in 2 or 3 other Circuits that read almost the same.

[KJohnson]

Good point by G Burns but the EBIA "green binders" note that the IRS has said that it will not follow Express Oil outside the 11th Circuit. They also note that even in the 11th the IRS might aruge that Express Oil only applies to FICA, FUTA and withholding but does not apply to what amounts are includible in an employee's income.

This is an area where I have always told people to just put in a 125 Plan and don't deal with the uncertainty.

[IRC401]

1. I believe that there is a PLR out there in which the IRS allowed government employees to make a one-time election between two benefit packages.

2. If PLR 9406002 is the one in whihc the IRS used the assignment of income doctrine to deny emplyees the right to choose between retirement and health benefits, keep in mind that it is a poorly reasoned PLR that isn't binding.

3. The IRS has never revoked Rev. Rul 60-31, even though it behaves as if it didn't exist.

[KJohnson]

Here is EBIA's "spin" on the PLR to which IRC401 refers. It can be found here:

http://www.ebia.com/weekly/articles/2001/C...4ConstRect.html

They note their own "raised eyebrows" regarding the reasoing behind this PLR and not 9406002

Employees Declining One-Time Chance to Take Lower Benefits with Higher Pay Not in Constructive Receipt

[Priv. Ltr. Rul. 200120024 (May 18, 2001)]

For a copy: http://www.irs.gov/pub/irs-wd/0120024.pdf

A recent IRS Private Letter Ruling found that a group of employees who were given a one-time election between a high-level benefits package, on the one hand, and a low-level benefits package plus an increase in compensation, on the other hand, were not found to have constructive receipt of income. The employees involved worked for a state-run tax-exempt employer that had two benefit packages. The first was a high-level benefits package, which provided health, dental, and life insurance, long-term disability benefits and the choice of either a defined benefit pension plan or a qualified money purchase plan (providing fully-vested contributions for participants). The second was a low-level benefits package, which provided less generous health and disability benefits, higher employee contributions for health coverage, and a lower employer contribution to the money purchase plan, in which benefits did not vest for five years. The employees were broken into two groups based presumably on work status: Group A employees were offered the high-level benefits package, and Group B employees were offered the low-level benefits package.

Noting a trend of Group A personnel leaving employment to obtain more pay with lesser benefits, the employer wanted to permit Group A employees to make a one-time irrevocable election to switch from the high-level benefits package to the low-level benefits package coupled with an 8% increase in compensation. But Group A employees who elected not to switch would not suffer any adverse consequences--they would continue to receive the same pay and high-level benefits as before. The employer requested--and received--two favorable rulings from the IRS.

First, the IRS ruled that the one-time election between the two benefits packages and the accompanying increase in compensation for those who moved to the low-level benefits package was not a cash or deferred election under Code Section 401(k). The IRS reasoned that those who decided to keep the high-level benefits package would not receive any additional benefit accruals under the retirement plan, nor were employees given a chance to participate in any other retirement program. In addition, the increase in pay for those who switched to the low-level benefits package did not result in an increased deferral for those who elected to keep the high-level benefits package.

Second, the IRS ruled that the employees who chose to keep the high-level benefits package did not have constructive receipt of income even though they could have received increased pay if they switched to the low-level benefits package. Income is "constructively received" in the taxable year in which it is credited to the taxpayer's account, set apart for the taxpayer, or otherwise made available so that the taxpayer could have drawn upon it at any time, or so that the taxpayer could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, there is no constructive receipt (and consequently no taxation) "if the taxpayer's control of its receipt is subject to substantial limitations or restrictions." The IRS reasoned that the employees given this one-time election had a "substantial limitation on the right to receive the increased compensation" because in choosing the low-level benefits package, they had to give up the more generous benefits in the high-level benefits package.

EBIA Comment: The IRS's reasoning on the ruling regarding 401(k) deferrals seems reasonable and logical, but we raise our eyebrows at the analysis on the ruling regarding the constructive receipt issue. When, as here, employees are given a choice between cash and benefits (some non-taxable and some taxable later, like pension benefits), it would seem that those employees that elected to keep the higher level would be deemed to be in constructive receipt of the cash that they could have received in lieu of benefits. Perhaps the one-time nature of the election caused the IRS to look the other way. Note that the ruling did not mention Code Section 125, and it was written by a different branch of the IRS (Branch 5) than the branch that normally addresses Section 125 issues (Harry Beker's Health and Welfare Branch). For more information, see EBIA's Cafeteria Plans manual at Section II.D ("With No Cafeteria Plan, What Are the Tax Consequences of Offering Employees a Choice of Higher Pay With No Benefits vs. Lower Pay With Benefits?"). For information about EBIA's manuals visit (http://www.ebia.com/publications/index.html)

Contributing Editor(s): Thanks to attorney Sharon R. Cohen for her contributions to this article, with final editing by EBIA staff. Ms. Cohen is Group and Health Care Counsel for Watson Wyatt Worldwide, an international benefits consulting firm in Washington D.C., and is a contributing editor of EBIA's Cafeteria Plans manual.

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