November 5, Internal Revenue Service P.O. Box 7604 Ben Franklin Station Washington, DC Re: CC:PA:LPD:PR (REG ), Room 5203

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1 Internal Revenue Service P.O. Box 7604 Ben Franklin Station Washington, DC Re: CC:PA:LPD:PR (REG ), Room 5203 Dear Sir or Madame: Buck Consultants, a leading international employee benefits and human resources consulting firm, appreciates this opportunity to submit comments on the proposed regulations issued under Section 125 of the Internal Revenue Code. The main focus of our commentary relates to the nondiscrimination rules. However, there are several other areas that we would like to note briefly first. ISSUES OTHER THAN NONDISCRIMINATION RULES 1. Plan Document Requirements Most employers have made a good-faith effort to prepare cafeteria plan documents in accordance with the Section 125 requirements. Very often, these documents are designed to comply at the same time with the ERISA plan document requirements. A common approach is to write an omnibus or wrap-around plan document that incorporates other benefit documents or SPDs by reference and attempts to satisfy both ERISA and Section 125. This has led to inconsistencies in omnibus plan coverage: Dependent care assistance plans may be part of the cafeteria plan, but they are not part of an ERISA plan. Dependent life insurance may be an ERISA plan, but may not be part of a cafeteria plan. The proposed regulations, in Section (c), as interpreted by government officials in informal comments, take a strict reading of the plan document requirement, and prohibit the document from including any nonqualified benefits. Suggested approach: Allow greater flexibility in the documentation requirements. For example, an omnibus document should be permitted to include nonqualified benefits if there is a clear statement that only the qualified benefits are part of the Section 125 plan. 2. Election Periods for New Employees The proposed regulations, in Section (d), permit a new employee to make an election within 30 days after the date of hire that is effective as of the date of hire. This is a welcome relief from the current rule.

2 Page 2 Many employers grant eligibility on the first day of the month following the date of hire, and would like to use the 30-day election period, but limit retroactivity to the date of eligibility, rather than the date of hire. Suggested Approach: Allow an employer who uses the new 30-day election period to limit the retroactive effect to any day within the 30-day period. 3. Dependent Care Spending Accounts The proposed regulations, in Section (a)(4), set out rules for dependent care reimbursements, and provide an example in which non-refundable day care center fees that are later used to offset monthly care fees are reimbursable. Many child care centers require non-refundable fees in addition to the monthly fee, with no subsequent offset. Because there is no other discussion of non-refundable fees other than in the example, it is not clear whether such a fee is reimbursable. Suggested Approach: Permit the reimbursement of a non-refundable day-care fee that is not offset against later monthly fees as an expense incurred on the first day dependent care is actually provided. 4. Interaction with State Law Mandates Massachusetts requires employers to maintain a cafeteria plan to permit employees to purchase health coverage. Employees who are not eligible for the employer s health plan must be allowed to purchase insurance through a state purchasing arrangement, known as the Connector, using salary reduction contributions. The Connector s purchasing process is structured so that the employee s salary will be reduced almost 2 months before the related health insurance coverage is provided. This raises two problems under Section 125: Deferral of compensation: Contributions in the last month of a year that are used to purchase insurance in the following year may be a deferral of compensation that is prohibited under the Section 125 rules because those contributions are being used to purchase coverage for the second month of the following year. Irrevocable advance elections: When an employee terminates Connector coverage, the employee will have a credit balance as a result of the pre-payment requirement. The Connector will return this amount to the employer, with the expectation that the employer will return it to the employee. It is not clear that the employer may return this amount under Section 125. First, the Connector coverage can be dropped without regard to whether there has been a change in status or other election change event. Under existing cafeteria plan rules, a coverage change is permitted without an election change event, but only if the employee does not change his or her salary reduction amount. Second, even if the change were permitted under Section 125, this is a retroactive adjustment to a salary reduction election, when Section 125 generally requires that changes be prospective.

3 Page 3 Suggested approach: We do not recommend tailoring the Section 125 rules to the Massachusetts situation. Several other states are looking into similar mandates, which may have different standards that would raise separate and potentially conflicting issues. Instead, we would like to see a general carve-out for any plan provision that is implemented to comply with a state mandate. This will allow employers flexibility to meet state mandates without violating Section Self-funded Plans Most major companies self-fund some or all of their health coverage. They will use a consultant, actuary or underwriter to estimate costs and develop premiums that will be used for COBRA purposes and as the basis for employee/employer cost-sharing. The proposed Section 125 regulations consistently use the terms insurance and premiums when referring to qualified benefits such as health coverage. Read literally, this would not include self-funded plans. Although there are sections of the Internal Revenue Code for which the distinction between a self-funded plan and an insured plan is important (i.e., Section 105(h)), we do not believe that to be the case with Section 125. Suggested approach: Clarify that references to insurance and/or premiums may also refer to selffunded plans, especially in the context of premium-only plans. Note, however, that it may be necessary when using the term premium to distinguish between the amount the employee pays toward coverage, and the combined employer/employee cost of the coverage (sometimes called the imaginary premium in a self-funded context). NONDISCRIMINATION TESTING While we sympathize with the difficulty of drafting regulations under the Section 125 nondiscrimination rules, there are several areas we believe could be clarified or simplified within the constraints of the statutory requirements. 1. Highly Compensated Individual Welfare plan discrimination testing uses a variety of definitions of the prohibited group. For example, Section 105(h) looks at the top 25%, Section 79 looks at key employees, and Sections 129 and 137 look at the pension definition of highly compensated employee. The proposed regulations, in Section (a), define a highly compensated individual in a way that differs from all the other Code sections. This difference is not required by the statutory wording of Section 125. Suggested approach: Define highly compensated individual in the same way it is defined for pension, dependent care, and adoption assistance purposes. This will reduce the data collection requirements for Section 125 testing, without opening the door to abusive practices.

4 Page 4 2. Eligibility Test Clarification The proposed regulations, in Section (b), establish the nondiscriminatory classification test under the Section 410(b) regulations as the standard for satisfying the eligibility test for a cafeteria plan. The regulations then proceed to give four examples in which a cafeteria plan is found to discriminate in eligibility when it has separate benefit and contribution structures that favor highly compensated employees. It is not clear why this is an eligibility issue, when all employees are in the plan, and only the benefits and contributions vary. If free disaggregation were permitted, then there would be an eligibility issue for the benefit structure covering the highly compensated individuals. However, the benefit structure covering the non-highly compensated individuals would be acceptable. If this is the rationale, it was not clear in the examples. Suggested approach: Provide clearer examples, and explain the logic behind each result. 3. Benefits Test - Valuation of Qualified Benefits The proposed regulations, in Section (c), establish a benefits utilization test in which the aggregate value of elected qualified benefits is compared to aggregate compensation. However, no guidance is given in valuing qualified benefits. Suggested approach: The value of qualified benefits should be the total nontaxable value of the coverage, and should include both the employer costs and employee salary reduction contributions to the coverage. In the case of self-funded plans, a reasonable premium similar to a COBRA premium could be used. 4. Uniformity Requirements A very common cafeteria plan design offers a uniform set of benefits to all participants, but charges premiums on a sliding scale that increases with pay. Executives pay significantly more than lower level staff for the same coverage. It is not clear whether this arrangement would still be permitted as a result of several uniformity requirements in the proposed regulations. The benefits test requires a cafeteria plan to give each similarly situated participant a uniform opportunity to elect qualified benefits (Section (c)(2)). Under the safe harbor for plans providing health benefits, excess contributions or benefits must bear a uniform relationship to compensation (Section (e)). Under the premium-only-plan safe harbor, the only example posits uniform premium payments (Section (f)).

5 Page 5 Suggested approach: Replace the concept of uniform with the concept of nondiscriminatory so that plans may continue to provide less expensive health coverage to lower paid employees. Use examples to clarify that this approach is acceptable. 5. Plan Disaggregation Disaggregating plans into separate benefit structures is useful for testing plans that have distinct benefit packages available to different groups of employees, or that charge different amounts for coverage. Under the old Section 89 rules, a plan could be freely aggregated or disaggregated into any number of separate benefit structures, as long as each structure was nondiscriminatory if tested separately. Under the proposed regulations, in Section (g), plans may be freely aggregated for nondiscrimination testing purposes, but may be disaggregated only into two plans, one for individuals with three years of employment and one for those with less than three years of employment. Suggested approach: Allow free disaggregation into any number of testing components. Under the proposed regulations, this result can be obtained by drafting each separate benefit structure as a separate cafeteria plan, and then aggregating them as necessary. However, this then becomes a form over substance rule that benefits those employers who can hire the cleverest benefit consultant. 6. Eligibility and Benefits Tests - Part-time Employees A current trend is for employers to offer part-time employees the option to buy into the health plan at the full cost (or at least at levels higher than full-time employees). In some instances, this option is offered in response to state law mandates; for example, Massachusetts employers may choose to extend coverage under their health plans to previously ineligible employees in lieu of having them obtain coverage through the Connector. These part-time employees were previously excluded from the health plan as permitted under Section 105(h) if the plan is self-funded, or as may be permitted under the group insurance contact. Employee contributions are made on a pre-tax basis through the employer s cafeteria plan, to take advantage of the tax savings. Some states, such as Massachusetts, mandate that employees be permitted to pay for coverage on a pre-tax basis through the employer s cafeteria plan. It is not clear that this would be permissible under the proposed Section 125 regulations. Parttime employees may not have the full range of benefits available to full-time employees, and the part-time employees must pay more for those benefits they do have. Suggested approach: Clarify how this may be done, either through disaggregation for testing purposes, or through establishment of a separate plan.

6 Page 6 7. Snapshot Date Testing Under the proposed regulations, nondiscrimination testing is to be performed on the basis of fullyear data. This makes data collection an unwieldy process, and increases the costs of performing the tests. Retirement plans are permitted to perform certain nondiscrimination tests on the basis of a representative snapshot date during the testing year. We believe that this approach would be equally valid for cafeteria plans. The incremental detail that a full-year test would provide would not justify the additional cost required. Suggested approach: Permit eligibility and benefits tests to be performed on the basis of a representative snapshot date during the testing year. 8. Correction Mechanism If the nondiscrimination rules are not met, highly compensated participants or key employees will recognize additional taxable income (Section (m)). In large corporations, this penalizes many individuals who have no control over plan design or operation. In addition, the time frame for finalizing nondiscrimination tests for inclusion on an employee s W-2 is unworkably short. Suggested approach: Establish a correction mechanism, similar to that available to qualified retirement plans, under which an employer may voluntarily correct minor violations, and so avoid taxation of highly paid individuals. CONCLUSION Buck appreciates the opportunity to provide our comments on the rules. We would be glad to discuss these with you further, if you would like additional information. Very truly yours, Pauline Ellis Director, Tax & Legal Consulting Diane Lotti Director, Research & Publications PE/DL DOC:L01376R