New IRS Proposed Cafeteria Plan Regulations

The IRS published the new proposed cafeteria plan regulations on August 6, 2007. The regulations are effective for plan years starting on or after January 1, 2009.

Pam Walker attended the annual ECFC (Employer’s Council on Flexible Compensation) TPA Symposium this year and the hot topic, of course, was the new regulations. Some of the highlights of the new regulations follow. These regulations replace the older proposed regulations and incorporate much of the prior IRS guidance. Most requirements remain unchanged; however, there are also numerous changes and clarifications to existing rules.

 

The regulations also incorporate several tax-law changes that have been made in the last few years (such as the new definition of dependent and the addition of HSAs as qualified benefits under a cafeteria plan).

 

Use-or-Lose Rule

 

The regulations change the previous “Use-it-or-lose-it” Rule term to the new term, “Use-or-Lose Rule.” It’s the same forfeiture rule as in the previously published regulations—just a different term. The new regulations continue the same rule.

 

Employers/Plan Sponsors may continue to adopt a 2-½ month grace period, extending the period for incurring expenses into the next Plan Year. The adoption of the grace period is optional and language must be included in the Section 125 Plan document.

 

Plan Year

 

The regulations confirm that a cafeteria plan year must be 12 months. A short Plan Year is allowed only if there is a valid business purpose unrelated to elections (examples are mid-year adoption or implementation of a Plan and a change in insurance carriers).

 

Self-Employed Individuals Ineligible

 

The regulations clarify that self-employed individuals are more-than-2% shareholders of a Subchapter S Corporation can’t participate in a cafeteria plan. This would include partners in a partnership and member/owners in an LLC.

 

New Excess Group Term Life Rule

 

Old rule was to tax greater of pre-tax amount or Table I value. New rule (effective 8/6/07) is to always tax the Table I value.

Individual Policy Premiums

The regulations clarify that individual policy premiums may be paid or reimbursed on a pre-tax or non-taxable basis (through the premium conversion benefit of the cafeteria plan). The payments or reimbursements may be made in the following ways:

 

• Direct reimbursement to the employee (as long as the employee substantiates the health insurance premiums);
• Payment to the insurance carrier; or
• Payment payable jointly to the employee and the insurance carrier.

Language must be included in the cafeteria plan document in order for individual policy premiums to be reimbursed. Also, caution should be used before allowing reimbursement for individual policy premiums due to potential COBRA and HIPAA issues.

 

Election Rules

 

The regulations clarify that the timing of the election must be made before the first day of the plan year (or other coverage period). In addition, the regulations allow for automatic (negative) elections, which is common for the payment of pre-tax premiums under the Employer-sponsored benefit plans.

 

However, the regulations provide a new retroactive election (up to 30 days) for new hires. This is particularly helpful for those employers with coverage that is effective on their date of hire. Further clarification is needed on this new provision regarding application to Flexible Spending Accounts (FSAs). (The regulations do not clarify if this retroactive election provision applies only to the cafeteria plan itself and any premium payment required for coverage.) Language must be added to the Section 125 Plan document in order to allow this new retroactive election provision and any pre-tax premium payment must be made on a prospective basis. Also, this provision doesn’t apply to terminated employees who are rehired within 30 days (or who take an unpaid leave of absence for less than 30 days).

 

In addition, the regulations require Employers to allow salary reduction changes to Health Savings Accounts (HSAs) at least monthly and as of the loss of HSA eligibility. (Please note that language must be included in the Section 125 Plan document and SPD to allow for pre-tax contributions to a Health Savings Account.)

 

The regulations also allow “default elections” for qualified benefits for new or current employees who fail to make timely elections (e.g., a previous year’s election could be deemed to continue unless changed), if certain procedures are followed.

 

Advance Payment for Orthodontia

 

Consistent with previous informal IRS guidance, the regulations confirm that Health FSAs may (but aren’t required to) reimburse advance payments for orthodontia services without violating the no-deferred-compensation rule, as long as the employee has actually made the advance payments in order to receive the services. This typically relates to lump-sum payments for orthodontia at the beginning of treatment (in order for the participant to receive a discount on the orthodontia services by paying in advance for the treatment). We do not recommend adding a provision for employees to “pay off” existing contracts if their contract has been written for a monthly payment plan. This creates potential liability for employers with terminated employees.

 

Other Clarifications on FSAs

 

Medical equipment with a useful life extending beyond the period of coverage in which the expense was incurred (e.g., a wheelchair) can also be reimbursed without violating the no-deferred-compensation rule.

 

Health FSA enrollments may be limited to employees who also participate in one or more of the employer’s accident and health plans. (Generally, employers do not limit eligibility in this manner to encourage higher participating in the Health FSA.)

 

The regulations clarify that a Dependent Care FSA may include a “spend-down” provision. This provision allows employees who terminate to continue to submit claims incurred after their termination date (as long as they are employment-related).

 

Substantiation

 

The regulations repeat the fact that FSA claims must be substantiated and clarify that employers are responsible for ensuring that any inventory information approval system (IIAS) used under their debit card program complies with applicable substantiation, reimbursement and recordkeeping requirements. 

 

Nondiscrimination Rules & Testing

 

Additional guidance is provided on the cafeteria plan nondiscrimination rules, including more detail regarding the definitions of highly compensated individual and key employee. A safe harbor is also established for premium-only cafeteria plans (commonly referred to as POPs).

 

Testing must be performed as of the last day of the plan year, but must take into account former employees. From a practical point of view, we all know how difficult it is to perform the testing at the beginning of the plan year (vs. performing the testing at the end of the Plan Year during open enrollment when little time exists to make changes for taxation and W-2 form purposes). Arcadia will be submitting written comments to the IRS regarding this issue, as from an administrative point of view, we believe it will be extremely difficult to wait until the end of the Plan Year to gather information and perform the testing.

 

Taxpayers may rely on the new proposed regulations for guidance until final regulations are issued. As mentioned above, some changes may require Plan document amendments and revisions to SPDs.

 

For a copy of the regulations, go to: 

 

http://edocket.access.gpo.gov/2007/pdf/E7-14827.pdf