After years of issuing various proposed regulations on Section 125 Cafeteria Plans, the Treasury Department and the IRS recently issued new proposed regulations replacing most of the previous citations. The good news is that the new rules replace previous final and proposed regulation that go as far back as 1984. These new regulations generally preserve the rules of the existing proposed regulations, while clarifying many regulatory and administrative provisions. Fortunately, the regulations clarify many areas in question such as the requirement for a plan document, how to apply the nondiscrimination rules, and the effect of noncompliance.

The following is a cursory overview of some of the areas that may be of interest to you:

1. Qualified and Non-Qualified Benefits in a Cafeteria Plan
   
   The rules clarify and amplify the general rule in regards to employee choice between taxable and nontaxable benefits to prevent the inclusion of the costs of these benefits as part of gross income. A plan can fail to satisfy the rules by:

   • Offering nonqualified benefits;
   • Not offering an election between a permitted taxable benefit and at least one qualified benefit such as accident and health benefits;
   • Deferring compensation;
   • Failing to comply with the use it-or-lose it rule;
   • Allowing employees to revoke elections or make new elections during a plan year except as allowed by Change in Election events such as leaves of absence, change in status, certain judgments or decrees, etc.;
   • Failing to comply with substantiation requirements;
   • Paying or reimbursing expenses incurred before the plan’s effective date or before a period of coverage;
   • Allocating experience gains (forfeitures) other than allowed by the regulations; and
   • Failing to comply with grace period rules.


2. Written Plan
   
   The rules require that a cafeteria plan be in writing and describe all benefits, rules for eligibility, and the procedure for making elections.


3. Participation
   
   Only employees may participate in a cafeteria plan. A participant’s spouse or dependents may receive benefits through a cafeteria plan but they cannot actively participate in the plan.



4. Qualified Benefits

   • Group-term life insurance;
   • Employer provided accident and health plans;
   • Health spending accounts;
   • Accidental death and dismemberment policies;
   • Dependent care assistance program;
   • Adoption assistance program;
   • Contributions to a 401(k) plan;
   • Contributions to certain plans maintained by educational organizations; and
   • Contributions to Health Savings Accounts (HSA).

   Group-term life insurance contributions can be paid by participants on a pre-tax basis but will still be subject to imputed income rules for excess coverage over $50,000. The old rules stated that imputed income was to be based on the greater of 1) actual contributions or 2) Table I imputed income for excess coverage over $50,000. The new rules provide that only the Table I costs are to be used for imputed income (less any applicable after-tax contributions). That means if the actual pre-tax costs are higher than Table I costs, then the employee enjoys a tax break on the difference. Because of the administrative nightmare of calculating imputed income on supplemental life pre-tax contributions, it is probably best to recommend payment of this coverage on an after-tax basis.




5. Nonqualified Benefits (not permitted to be offered)

   • Scholarships;
   • Employer-provided meals and lodging;
   • Educational assistance;
   • Fringe benefits;
   • Long-term care services;
   • Archer medical savings accounts;
   • Group-term life insurance on an employee’s spouse, child, or dependent; and
   • Elective deferrals to a section 403(b) plan.

   Note: Nonqualified benefits may not be offered through a cafeteria plan even if paid with after-tax employee contributions.



6. Employer Contributions
   
   A cafeteria plan may impose reasonable fees to administer the cafeteria plan which may be paid through salary reduction. A cafeteria plan is not required to allow employees to pay for any qualified benefit with after-tax employee contributions.


7. Elections in Cafeteria Plans
   
   A cafeteria plan is permitted to include an automatic election for new employees or current employees. New elections or changes in elections can be made electronically. Only an employee can make an election, revoke, or change his or her election. An employee’s spouse or dependent may not make an election under a cafeteria plan and may not revoke or change an employee’s election.



8. Flexible Spending Arrangements (FSA)

   • Regulations retain the uniform coverage rule for health FSA where the maximum amount of reimbursement must be available throughout the period of coverage (less any reimbursements already distributed);
   • Continuation of the use it-or-lose it clause;
   • Required period of coverage for 12 months. Expenses incurred before or after period of coverage may not be reimbursed;
   • May limit Health FSA enrollment to participation in employer’s accident and health plan;
   • Dependent care FSA permits employers to reimburse qualified expenses incurred after termination of employment; and
   • Forfeitures may be used to defray administrative expenses or allocated among contributing employees.


9. Substantiation of Expenses
   
   All reimbursements must be individually substantiated by a third party independent of the employee before expenses will be reimbursed. Among the permissible substantiation methods are co-payment matches, certain recurring medical expenses such as prescriptions, and real-time substantiation from an independent third party such as a medical care provider or a pharmacy benefit manager.


10. Nondiscrimination Rules
    
    New regulations provide additional guidance including definitions of key terms, eligibility test and the contribution and benefits tests, excludable employees, and a safe harbor test for premium-only plans.

In most cases, the new regulations apply for plan years beginning on or after January 1, 2009. Taxpayers may rely on these regulations now for guidance pending the issuance of final regulations.