IRS Issues New Proposed Cafeteria Plan Regulations

Transcription

1 IRS Issues New Proposed Cafeteria Plan Regulations The IRS recently issued new proposed regulations governing the operation of cafeteria plans under Section 125 of the Internal Revenue Code. These regulations replace earlier proposed regulations and guidance issued since Section 125 was enacted in The proposed regulations generally are intended to apply for plan years beginning on or after January 1, 2009, but can be relied on pending the issuance of final regulations. This For Your Information provides a broad overview of cafeteria plan rules in the context of the new proposed regulations. Background Under the tax doctrine of constructive receipt, an individual is taxed on income in the year in which he or she has an unrestricted right to receive it. This tax doctrine applies to employer-provided benefits an employee given the choice between receiving his or her full salary in cash and receiving non-taxable benefits ordinarily would be taxed on the cash that he or she could have received. Section 125 creates an exception for certain employer-provided benefits elected through a cafeteria plan an employee who makes an election between cash and nontaxable benefits through a cafeteria plan will not be taxed on the foregone salary as long as the plan meets all of the requirements of Section 125. First effective in 1979, Section 125 sets out a broad outline of the basic cafeteria plan requirements. The statute defines a cafeteria plan as a written plan under which all participants are employees and all participants may choose among two or more benefits consisting of cash and qualified benefits, which, with limited exclusions, are benefits that are not includible in an employee s income by reason of an express provision in the Internal Revenue Code. A cafeteria plan cannot provide for deferred compensation except as specifically provided. A cafeteria plan cannot discriminate in favor of highly compensated individuals as to eligibility to participate or in favor of highly compensated participants as to contributions and benefits. Over the years, the IRS has issued proposed regulations that elaborated on many of these requirements, as well as revenue rulings, notices and other guidance that addressed specific issues (e.g., grace periods), issues arising from intervening legislation (e.g., health savings accounts) or issues relating to new technology (e.g., debit cards). Recently, the IRS withdrew all of the existing proposed regulations and issued new proposed regulations that incorporate most of the intervening guidance, provide clarification on other issues and address some new issues that had not previously been addressed. The new proposed regulations do not change two important sets of regulations that were finalized in 2001, which relate to

2 the interaction of the cafeteria plan rules with the Family and Medical Leave Act rules governing permissible cafeteria plan election changes, such as those involving change in status events. The New Section 125 Proposed Regulations The new proposed regulations make it clear that Section 125 is the exclusive means by which an employer can offer employees an election between taxable and nontaxable benefits without the election itself resulting in inclusion in gross income by the employees. An employee who has an election that is not through a cafeteria plan satisfying Section 125 must include in gross income 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. Written Plan Document Requirement A cafeteria plan must be maintained and operated in accordance with a written plan document. If there is no written cafeteria plan, if the written plan fails to contain any required information, or if the plan is not operated in accordance with the document s terms or Section 125, the plan is not a cafeteria plan and all participants lose the tax-favored status of their benefits under the program. The new proposed regulations expand the information required to be in a cafeteria plan document. One new requirement is that the cafeteria plan document specifically state that participation is limited to employees. (Spouses and dependents may benefit under the coverage elected by an employee through the cafeteria plan but they may not be given the opportunity to elect or purchase benefits offered by the plan.) In addition, plans that offer paid time off, have flexible spending accounts, include grace periods, and those plans that provide for distributions from a health FSA to a health spending account must contain specific provisions that put them in compliance with the rules applicable to those arrangements. Plan Amendments. The new proposed regulations make it clear that any amendment to a cafeteria plan may only become effective for periods after the later of the adoption date or the effective date of the amendment and that if the amendment adds a new benefit, the plan can only pay or reimburse those expenses incurred after the later of those dates. BUCK COMMENT. Because a failure to comply with the plan document requirement could result in disqualification of the plan, plan sponsors should review their cafeteria plan documents to determine if they contain all required information and are being operated in accordance with their terms. Going forward, plan amendments will need to be formally adopted prior to their initial effective date a practice some plan sponsors may not have been following diligently. [ 2 ]

3 Permissible Benefits The proposed regulations reiterate that a cafeteria plan must offer employees a choice between at least one permitted taxable benefit and at least one qualified benefit. Permitted Taxable Benefits. The proposed regulations clarify that permitted taxable benefits are limited to cash compensation in the form of salary, payments for annual leave, sick leave or other paid time off and severance pay (but not distributions from a Section 401(a) qualified trust) and the following taxable benefits that are treated as cash property benefits attributable to employer contributions that are taxable to an employee upon receipt, such as group term life insurance on the life of an employee in excess of $50,000 benefits purchased with after-tax contributions (or benefits that the employee is treated as having purchased with after-tax contributions) other than the benefits noted on page 4. Health Coverage of Domestic Partners. The proposed regulations specifically permit a cafeteria plan to allow an employee to elect health coverage as a taxable benefit for a former spouse, domestic partner or other individual who is not a tax dependent. The employee may pay for the coverage through salary reduction, but the fair market value of the coverage must be included in the employee s gross income. Qualified Benefits. Qualified benefits are generally benefits attributable to employer contributions that are not currently taxable to the employee by reason of an express provision of the Internal Revenue Code and do not defer compensation. The proposed regulations clarify that only the following are qualified benefits group term life insurance on the life of an employee in an amount that does not exceed $50,000 accident and health plans, including health FSAs payment or reimbursement of employee s individual accident and health insurance premiums premiums for COBRA continuation coverage under the health plan of the cafeteria plan sponsor, even if the fair market value of the premiums is included in the employee s gross income premiums for COBRA continuation coverage for an employee of the cafeteria plan sponsor under the health plan of a different employer AD&D coverage long-term and short-term disability coverage dependent care assistance benefits adoption assistance benefits certain plans maintained by educational organizations to fund post-retirement group life insurance [ 3 ]

4 contributions to health savings accounts. BUCK COMMENT. It is important to note that while the payment of premiums for individual coverage or COBRA coverage may be made through the cafeteria plan, these premiums are not eligible expenses under a health FSA and thus cannot be paid or reimbursed through that arrangement. Benefits That Cannot Be Provided Through a Cafeteria Plan. The proposed regulations list specific benefits that cannot be offered through a cafeteria plan e.g., dependent life insurance coverage (regardless of whether such benefit is taxable or nontaxable), long-term care insurance, educational assistance benefits, and transportation benefits. The proposed regulations specifically state that a plan that provides any other type of impermissible benefit is not a cafeteria plan and as a result, even a participant who had only elected nontaxable benefits will have the value of the taxable benefit with the greatest value that he or she could have elected included in income. Change in Tax Treatment of Group Term Life Insurance. The proposed regulations change the method of imputing income for group term life insurance purchased through a cafeteria plan, effective immediately. Earlier guidance had required an employee to include in gross income the greater of the Table I rates for the cost of coverage in excess of $50,000 or the amount of salary reduction and flex-credits. The proposed regulations now limit the amount includable in income to the Table I cost of the excess coverage (minus after-tax contributions). All salary reduction and flex credits are excludable from income, even if used to purchase group term life coverage in excess of $50,000. BUCK COMMENT. This change could result in less imputed income for plan participants. Because this change became effective on August 6, 2007, employers that report imputed income on a pay period or quarterly basis may have to revise the amounts reported. Participation Limited to Employees The proposed regulations make it clear that although an employee s spouse or dependents (and even certain non-dependents) may benefit from an election made under a cafeteria plan, only employees may participate in a cafeteria plan. For this purpose, participation results from the opportunity to elect or purchase benefits offered under the plan. The proposed regulations clarify that the term employee includes the following current or former employees common law employees leased employees described in Section 414(n) full-time life insurance salesman described in Section 7701(a)(20). Self-employed individuals, partners, 2% shareholders in an S corporation or directors serving solely on a corporation s board of directors and not performing services as an employee are not employees and are not permitted to participate in a cafeteria plan. However, certain dual status individuals (i.e., individuals who provide [ 4 ]

5 services to the employer both as an employee and as an independent contractor or director), may participate solely with respect to their compensation as an employee. Prohibition against Deferred Compensation Generally a plan will violate the prohibition against deferred compensation if it permits employees to carry over unused elective contributions, after-tax contributions or plan benefits from one plan year to another, or if it permits employees to use contributions for one plan year to purchase benefits to be provided in a subsequent plan year. A plan that violates this prohibition is not a cafeteria plan and an election between taxable and non-taxable benefits will result in gross income to the employee. Permissible Deferred Compensation Arrangements. The prohibition against deferred compensation does not apply to elective contributions to a 401(k) plan elective contributions to a plan maintained by certain educational organizations to pay for post-retirement group life that meets certain conditions contributions to HSAs (but not Archer MSAs) grace periods of no more than two and one-half months that satisfy other requirements. (See our May 19, 2005 Newsflash.) The proposed regulations also specify that the following practices do not result in the deferral of compensation using salary reduction amounts from the last month of one plan year to pay accident and health premiums for the first month of the immediately following plan year, if done on a uniform and consistent basis for all similarly situated participants mandatory two-year elections for vision or dental coverage if the premiums for each plan year are paid no less frequently than annually (i.e., the premium for the second year is not paid more than a year in advance) and salary reduction and flex credits relating to the first year of a two-year election do not apply to the second year of the election. The proposed regulations clarify that many common features of accident and health policies that may relate to more than one year, such as lifetime limits, level premiums, premium waivers during disability and guaranteed renewability of coverage (but not premiums) will not be considered to defer compensation if no part of any benefit is used in one plan year to purchase a benefit in a subsequent plan year, the policies remain in force only so long as premiums are paid on time, there is no investment fund or cash value to rely upon for payment of premiums and no part of any premium is held in a separate account. They also clarify that benefits under long-term disability policies that pay benefits over more than one year and reasonable rebates or policy dividends paid within 12 months of the close of the cafeteria plan year to which they relate do not defer compensation. [ 5 ]

6 Paid Time Off (PTO). The proposed regulations retain the rules regarding elective vacation pay and expand them to include all paid time off (i.e., vacation, paid sick days or personal days). Elective PTO must be used, paid in cash or forfeited no later than the last day of the plan year in which it was elected. If an employee has both elective and non-elective PTO, the nonelective PTO is deemed to be used before elective PTO. No grace period is available for the use of PTO. Cafeteria Plan Elections The proposed regulations provide the following clarifications and additional new rules. Automatic Elections. The proposed regulations specifically permit a cafeteria plan to have automatic elections for new employees (i.e., an employee is deemed to elect specified qualified benefits unless he/she affirmatively elects cash or other alternate benefit options) or for current employees who fail to make an election during annual enrollment (e.g., an election made for any prior year is deemed to be continued unless changed). Optional Election for New Employees. The proposed regulations permit a cafeteria plan to give new employees 30 days after their initial hire date to make their cafeteria plan elections and have the election effective as of their hire date. Salary reductions must be made from compensation not available on the date of election. The plan must provide that any employee who is rehired within 31 days after terminating employment or who returns to employment following an unpaid leave of absence is not eligible for this election. BUCK COMMENT. This optional election is apparently only available for cafeteria plans that provide eligibility to participate on the date of hire. A cafeteria plan that imposes a waiting period for participation (e.g., delays eligibility until the first day of the month following completion of 30 days of employment) could not use this provision to provide for coverage retroactive to the employee s eligibility date if the employee did not submit an election form until after he or she became eligible. Salary Reduction Contributions to HSAs. The proposed regulations clarify that a cafeteria plan offering HSA contributions through salary reduction must specifically describe the HSA contribution benefit, and must allow a participant to make prospective salary reduction election changes for HSA contributions on a monthly (or more frequent) basis, including a revocation of an election for a participant who becomes ineligible for HSA contributions. Additional FSA Guidance The regulations generally address a number of issues relating to flexible spending arrangements. They retain, for example, the use-it-or-lose-it rule and incorporate earlier guidance regarding HSA-compatible health FSAs and HRAs and rollovers from health FSAs to HSAs. (See our March 8, 2007 For Your Information.) They also clarify several issues. [ 6 ]

7 Adoption Assistance FSAs. The proposed regulations add adoption assistance FSAs as a qualified benefit that may be offered through a cafeteria plan. Generally, adoption assistance FSAs are treated in the same manner as dependent care FSAs in that they are not subject to the uniform period of coverage requirement applicable to health FSAs. 12-Month Period of Coverage. Generally, an FSA must have a 12-month period of coverage. In the case of a short plan year, the period of coverage will be the entire short plan year. Different Periods of Coverage for Different Benefits. A dependent care FSA, adoption assistance FSA and a health FSA may each have different coverage periods, and the period of coverage may be different than the plan year of the cafeteria plan. Orthodontia Expenses. Orthodontists frequently require a significant payment in advance of services being provided and care typically extends over more than one plan year. The IRS previously indicated in an information letter that a health FSA could reimburse an employee for payments made to orthodontists before services were actually rendered. The proposed regulations now formally permit, but do not require, a health FSA to reimburse these advance payments in the year in which they are made, if the payment was required in order to receive orthodontic services. BUCK COMMENT. Employers need to weigh the administrative convenience of reimbursing large advance payments with their increased risk of loss if an employee receives reimbursement early in a plan year and then terminates employment shortly thereafter. The proposed regulations limit reimbursement of advance payments to orthodontic expenses and do not extend it to payments for other types of medical services, such as treatment for infertility, that like orthodontia, may require an advance payment and may involve care that extends over more than one plan year. Substantiation of Claims by Post-Deductible Health FSAs. A post-deductible health FSA is a type of HSAcompatible health FSA that reimburses only preventive care expenses or medical expenses incurred after the minimum annual high deductible health plan (HDHP) deductible has been satisfied. The proposed regulations require a participant submitting a claim for reimbursement from a post-deductible health FSA to provide confirmation from an independent third party that the expense was for medical care and that the annual deductible has been satisfied. Treatment of Forfeitures. The proposed regulations provide that FSA forfeitures may be retained by the employer maintaining the cafeteria plan, or if not retained, may be used to defray plan administrative expenses used to reduce required salary reduction amounts for the next plan year on a reasonable and uniform basis returned to employees on a reasonable and uniform basis. [ 7 ]

8 A plan may allocate the forfeitures on a per capita basis weighted to reflect participants elected levels of coverage (but not based on actual claims experience). For example, participants who elected to contribute $1,000 could receive an allocation that was two times greater than participants who elected to contribute $500. Terminated Participants. The proposed regulations provide that if an employee made an FSA contribution for a period of coverage that extends beyond the date participation ends, the plan must repay the former participant the amount related to the period after the date the employee ceased to be a participant. Substantiation of Claims The proposed regulations generally retain the rules regarding substantiation of claims as set out in prior guidance, including the rules regarding the use of debit cards. (See our May 27, 2003, July 18, 2006 and December 20, 2006 For Your Information publications.) They also provide other clarifications. Spend-Down Option for Dependent Care FSAs. The proposed regulations specifically permit employees to spend down balances remaining in the dependent care FSA at the time participation ends by letting them submit dependent care expenses incurred after participation ends but before the end of the plan year. Employers are not required to permit this spend-down, but if allowed, it must be specifically authorized in the cafeteria plan document. BUCK COMMENT. Some cafeteria plans already permitted this type of spend-down on the basis that the uniform coverage rule did not apply to dependent care FSAs. Clear language permitting the practice is welcome. Nonrefundable Deposits for Dependent Care. The proposed regulations clarify that nonrefundable deposits to reserve a space at a child care facility are reimbursable if and when they are subsequently applied towards the cost of child care services provided during the same period of coverage. Nonrefundable deposits that are not applied towards the cost of child care provided during the period of coverage are not reimbursable. New Nondiscrimination Requirements Section 125 provides that the exception to constructive receipt does not apply to highly compensated participants or key employees if the plan discriminates in favor of them with respect to eligibility, contributions or benefits. However, there was very little guidance on how the various nondiscrimination tests were to be applied. The proposed regulations now provide definitions of key terms and guidance on the eligibility test and the contributions and benefits test. Definition of Key Terms. For purposes of discrimination testing, Section 125 uses the term highly compensated individual. This term is similar, but not identical, to the definition of highly compensated employee in Section 414(q) that is generally used for qualified retirement plan purposes. The proposed regulations define a highly compensated individual as an officer (in the preceding year or in the current year if a new employee) [ 8 ]

9 a 5% shareholder (determined without attribution) in the preceding or current plan year an employee who in the preceding year (or in the current year if a new employee) received compensation in excess of the Section 414(q) compensation threshold ($100,000 in 2007) and, if elected by the employer, was in the top-paid group of employees (generally the top 20%) the spouse or dependent of any of the above. Eligibility Nondiscrimination Test. The proposed regulations incorporate by reference the nondiscriminatory classification test under Section 410(b) that applies to qualified retirement plans, except that this test is modified by substituting highly compensated individuals and non-highly compensated individuals for highly compensated employees and non-highly compensated employees. A plan will satisfy the eligibility nondiscrimination test if it benefits a group of employees who qualify under a reasonable classification established by the employer and the group of employees included in the classification satisfies the safe harbor percentage test or the unsafe harbor percentage component of the facts and circumstances test set out in regulations under Section 410(b). Employees (other than key employees) covered by a collectively bargained plan, certain nonresident aliens who receive no U.S. source earned income and employees participating in the cafeteria plan through COBRA are excluded from testing. Examples in the proposed regulations suggest that for purposes of running the eligibility nondiscrimination test, each benefit option and each payment level is treated as if it were a separate plan. In one example, a cafeteria plan that provided the same qualified benefit to all participants but provided only highly compensated employees with flex credits that could be used to pay for a portion of the premium failed the eligibility test. In another example, a cafeteria plan failed the eligibility test when it offered a high deductible health plan to non-highly compensated employees and a low deductible health plan to only highly compensated employees, yet charged them the same premium. BUCK COMMENT. The new eligibility test seems to be a misnomer since it appears to focus on the actual benefits offered through the cafeteria plan, something that logically would be addressed in the contributions and benefits test. Contributions and Benefits Nondiscrimination Test. The proposed regulations clarify that in order to satisfy the contributions and benefits test, not only must each similarly situated participant be given an equal opportunity to elect qualified benefits, but highly compensated participants must not disproportionately elect qualified benefits while other participants elect to receive employer contributions and permissible taxable benefits. The proposed regulations set out a new objective test for determining whether highly compensated participants have disproportionately elected qualified benefits i.e., if the aggregate qualified benefits elected by highly compensated participants, calculated as a percentage of compensation, exceed the aggregate qualified benefits elected by non-highly compensated participants, calculated as a percentage of compensation. BUCK COMMENT. The new proposed regulations do not specify how to determine the value of the qualified benefit under this test. Additional guidance would be helpful. [ 9 ]

10 Key Employee Concentration Test. The proposed regulations clarify that if key employees in the aggregate receive more than 25% of statutory nontaxable benefits (e.g., dependent care assistance benefits, employerprovided health coverage, adoption assistance benefits, 401(k) plan contributions, and contributions to HSAs) provided to all employees under the cafeteria plan, each key employee must include in gross income an amount equal to the maximum taxable benefits he or she could have elected for that plan year. Health Benefit Safe Harbor. Section 125 provides that a cafeteria plan providing health benefits will not be treated as discriminatory with respect to contributions and benefits if both of the following are satisfied contributions under the plan on behalf of each participant include an amount that equals 100% of the cost of the health coverage under the plan of the majority of similarly situated highly compensated participants, or equals or exceeds 75% of the cost of the participant having the highest cost benefit coverage under the plan contributions or benefits in excess of those described above bear a uniform relationship to compensation. The proposed regulations clarify that this safe harbor is limited to major medical coverage and does not apply to dental coverage and health FSAs. They also provide that in determining which participants are similarly situated, employers may take into account reasonable differences in plan benefits offered to employees working in different geographical locations or to employees with family coverage versus employee-only coverage. Premium-Only Plan Safe Harbor. The proposed regulations create a safe harbor for a cafeteria plan that offers an election between cash and payment of the employee share of the employer-provided health insurance premium as its sole benefit. A premium-only cafeteria plan qualifies for the safe harbor if it passes the reasonable classification and safe harbor percentage tests under Section 410(b). Permissive Disaggregation Rule. Cafeteria plans that allow employees with less than three years of service to participate in the plan are permitted to disaggregate the plan into two separate plans for nondiscrimination testing purposes e.g., one plan for employees with less than three years of service and one for employees with three or more years of service. If a plan is disaggregated into two separate plans, the two plans must be tested separately for both the eligibility test and the contribution and benefits test. Optional Aggregation Rule. The proposed regulations permit an employer that sponsors more than one cafeteria plan to aggregate the plans for purposes of nondiscrimination testing. If two or more plans are aggregated, the combined plan must satisfy both the eligibility test and the contribution and benefits test. Time for Performing Nondiscrimination Testing. Employers will be required to perform cafeteria plan nondiscrimination testing as of the last day of each plan year and must take into account all non-excludable employees or former employees who were employees on any day during the plan year. Consequences of Failure. If a plan fails any of the nondiscrimination tests, the adverse tax consequences affect only highly compensated participants and key employees. The proposed regulations clarify that if a plan is found to be discriminatory, the highly compensated or key employee is taxed on the value of the benefit with the greatest value that the employee could have elected to receive. [ 10 ]

11 Conclusion While providing welcome guidance, the new regulations are lacking in certain areas, particularly in specifics as to how the new nondiscrimination rules function. We hope the IRS will offer further clarification of these rules. Plan sponsors should nonetheless begin to assess their current plan practices and bring them in line with the new guidance to the extent possible. Buck s consultants would be pleased to discuss how the new proposed regulations may affect your cafeteria plan. This FYI is intended to provide general information. It does not offer legal advice or purport to treat all the issues surrounding any one topic. [ 11 ]