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Consequences for Failing Cafeteria Plan Eligibility Nondiscrimination Test


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Hypothetical:  Employer A's cafeteria plan provides for immediate entry (i.e., no waiting period) into plan.  Employer A is acquiring a new company, Seller, whose cafeteria plan provides for a 60-day waiting period.  The vast majority of highly compensated employees are employed by Employer A.  For a number of reasons, Employer A wants to keep this eligibility structure for a while, say, six months.

Assume that Employer A is taking the conservative approach that this violates the eligibility portion of the cafeteria plan nondiscrimination tests.  (I recognize that there are those in this forum that take the very reasonable position that this structure would not violate these tests because it is the underlying benefit that has a waiting period, not the cafeteria plan.)

My questions are two-fold:

1-What highly compensated employees would be affected (i.e., incur extra taxes) by this nondiscrimination failure?  Just ones who are hired by Employer A during the six month period and who can enroll in plan without the waiting period?  All highly compensated employees who elected to pay for qualified benefits on a pre-tax basis? All highly compensated employees whether or not they elected to do so?  What if no employee is hired at Seller during that period?

2-For those who are affected, for what amount will they be subject to extra taxes?  Is it based on their full election for the year or for only the two-month waiting period that they are not subject to?


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I'm one of those who takes the position that this probably isn't a Section 125 eligibility test violation.  But accepting the premise that it does violate the rules, I read the regs to say that all HCEs would have all cafeteria plan pre-tax contributions for the full plan year recharacterized as taxable income.  I think there would likely be a standard three-year statute of limitations for going back to prior years and issuing corrected Forms W-2c.

Prop. Treas. Reg. §1.125-7(m):

(m) Tax treatment of benefits in a cafeteria plan.

(1) Nondiscriminatory cafeteria plan. A participant in a nondiscriminatory cafeteria plan (including a highly compensated participant or key employee) who elects qualified benefits is not treated as having received taxable benefits offered through the plan, and thus the qualified benefits elected by the employee are not includible in the employee's gross income merely because of the availability of taxable benefits. But see paragraph (j) in §1.125-1 on nondiscrimination rules for sections 79(d), 105(h), 129(d), and 137(c)(2), and limitations on exclusion.

(2) Discriminatory cafeteria plan. A highly compensated participant or key employee participating in a discriminatory cafeteria plan must include in gross income (in the participant's taxable year within which ends the plan year with respect to which an election was or could have been made) the value of the taxable benefit with the greatest value that the employee could have elected to receive, even if the employee elects to receive only the nontaxable benefits offered.

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