Flexible spending arrangements

[Ken Davis]

May an FSA be offered outside a cafeteria plan? We have a salary-reduction FSA (at least, that's what we call it), and I've always heard it referred to as part of a cafeteria plan, but the question was raised when I read a sentence in the 1996 Tax Act Blue Book (where it is discussing the addition of section 106©) that said FSA may be offered outside a cafeteria plan (but did not elaborate on the point).

If the FSA is outside the cafeteria plan rules, what tax rules control the taxation of benefits to the employee?

Thanks,

Ken Davis

Univ. of South Alabama

[GBurns]

The same as applies to an FSA within a Cafeteria PLan, namely, Proposed Treas Regs 1.125-1 and 1.125-2 etc. In particular 1.125-2 Q&A 7.

[QDROphile]

Are you asking if you can have salary reductions fund the FSAs outside of a cafeteria plan or are you simplay asking about the tax consequences of the payments or reimbursements from the accounts?

[Ken Davis]

I wasn't clear about the questions in my original post.

Specific questions are:

1. May a salary-reduction FSA can be set up outside of a cafeteria plan?

2. What tax rules would control the taxation of the salary-reduction election? For example, must the election be made prior to earning the salary to avoid the constructive receipt rules?

3. What tax rules control the taxation of benefits provided under the FSA?

4. Any restriction on benefits that may be offered under an FSA formed outside the cafeteria plan rules?

Thanks,

Ken

[QDROphile]

No to #1. Salary reduction funding must comply with cafeteria plan rules unless you want to talk about after tax funding, which won't make sense to pursue. That may effectively take care of the other questions.

[oriecat]

Is this just an issue of confusing a cafeteria plan with a Section 125 plan? We have an FSA through our Section 125 plan. It is not a cafeteria plan.

[GBurns]

A section 125 plan is a cafeteria plan and a cafeteria plan is only and always a section 125 plan.

The only cafeteria plan that is not a section 125 plan would be one related to your lunchroom (a cafeteria for food).

You can have a health FSA that is outside a cafeteria plan but only if there are no employee salary reduction contributions.

[mbozek]

There is uncertainty of whether the cafeteria plan rules are the exclusive means of providing pre tax welfare benefits since 125 refers to a plan under which the employee is given a choice between cash and benefits, e.g the constructive receipt issues which the IRS used against salary reduction in both cafeteria plans and retirement plans. Some IRS officials in the Carter administration claimed that salary reduction was tax avoidance which should be taxed. It was no coincidence that Congress enacted IRC 125, 401k and the moratorium on IRS issuing rulings on non qual deferred comp salary reduction in the 1978 Revenue Act. The unanswered question is whether an employer can have a pre tax health plan where the employee has no choice between cash and benefits, i.e., compensation is reduced as a condition of employment to pay for health care.

[Ken Davis]

No to #1. Salary reduction funding must comply with cafeteria plan rules unless you want to talk about after tax funding, which won't make sense to pursue. That may effectively take care of the other questions.

QDROphile,

Certainly not to doubt your answer or expertise, but for my own education can you give a basis for your statement that a pre-tax FSA may not be offered outside the cafeteria plan rules?

Thanks,

Ken

[GBurns]

I more think that it is you, Ken, who should state why you think that salary reduction (for this purpose) can be done without a cafeteria plan since you are the one questioning the established albeit only Proposed Regs, long standing tradition etc and the response by mbozek.

mbozek points out there is some grey involved regarding the exclusivity of 125. Cases such as Express Oil Change etc do not resolve the issue. So unless you want to also challenge the IRS regarding this issue 1.125-1 and 1.125-2 are what we go by.

So while 1.125-2 Q&A7 shows that there can be an FSA outside a Cafeteria Plan, there is nothing that allows pre-tax funding of such an FSA, which leaves us with employer only funding or after-tax funding of an FSA that is outside of a cafeteria plan.

[QDROphile]

While I agree with GBurns, I will try to give a simple answer that I hope makes sense to you.

If an employee is entitled to have cash compensation, the IRS treats the employee as if the employee got it unless a special rule applies. It does not matter if the emplyee says he/she does not want it now or chooses something else instead. See Rev. Rul. 60-31.

Under a salary reduction FSA, the employee is choosing to have the employer pay health benefits. The employees is choosing medical benefits (which happens to be nontaxable) instead of the cash that the employee could have taken. Without some special rule, the IRS would treat the employee as if the employee had received the cash. The amount would be included in income for tax purposes (i.e. not "pre-tax' in the unfortunate common vernacular).

That special rule is found in section 125 of the Interna Revenue Code. If the arrangement does not comply with section 125, the emplyee does not exclude the forgone compensation from taxable income.

[Ken Davis]

I more think that it is you, Ken, who should state why you think that salary reduction (for this purpose) can be done without a cafeteria plan since you are the one questioning the established albeit only Proposed Regs, long standing tradition etc and the response by mbozek.

mbozek points out there is some grey involved regarding the exclusivity of 125. Cases such as Express Oil Change etc do not resolve the issue. So unless you want to also challenge the IRS regarding this issue 1.125-1 and 1.125-2 are what we go by.

So while 1.125-2 Q&A7 shows that there can be an FSA outside a Cafeteria Plan, there is nothing that allows pre-tax funding of such an FSA, which leaves us with employer only funding or after-tax funding of an FSA that is outside of a cafeteria plan.

GBurns,

You are putting words in my mouth that I never said. I suggest you reread my posts in this matter and you will see that nowhere did I say I thought "that salary reduction (for this purpose) can be done without a cafeteria plan . . ."

And where did I question the "Prosposed Regs, long standing tradition etc and the response by mbozek"?

If I believe the answers to my question (May a salary-reduction FSA be set up outside a cafeteria plan?) leave something to be desired, then it is my right and my obligation to those to whom I report to ask for further clarification. It is your right to not offer a response.

Ken

[GBurns]

Ken,

You asked " ..can you give a basis for your statement that a pre-tax FSA may not be offered outside the cafeteria plan rules?" in response to a post that pointed you to the Proposed Treas Regs and both mbozek's and QDROphile's explanations of the IRC and the same Regs.

What else could you have been doing but questioning that it cannot be done, thereby meaning that you think that it can be done since the basis for QDROphile's statement was already given, namely the Proposed Treasury Regs and the IRC?