Nearly a quarter century after the Internal Revenue Service (IRS) started releasing piecemeal proposed regulations on cafeteria plans, employers now have new, updated guidance from the IRS on important topics such as nondiscrimination testing and debit card programs. Not final regulations, mind you, but at least a new set of coordinated proposals to replace the old ones.
Employers can rely on these rules now, even though they are generally not intended to take effect until January 1, 2009. The new rules, which leave in place the existing “change in status” rules, are designed to incorporate years’ worth of legislative developments (notably Health Savings Accounts, or HSAs) and prior rulings. More importantly, these proposals may indicate a new degree of scrutiny of cafeteria plans by the IRS.
These proposals emphasize that cafeteria plans are the exclusive way for an employer to allow employees to choose between taxable and nontaxable benefits without having that election itself generate taxable income. They also emphasize that violations of the rules undermine a plan’s status as a cafeteria plan, meaning that salary reduction elections could not be made without paying income and employment taxes.
One significant change relates to the prohibition under Code Section 125 of discrimination as to eligibility and in contributions and benefits in favor of “highly compensated” employees (in this context, generally officers, 5% shareholders and those with annual compensation above a set level – $100,000 in 2007). Employers have not always applied these nondiscrimination rules as rigorously as they apply, for example, those that cover 401(k) plans.
That may change if these proposed rules become final. Employers would specifically be required to perform nondiscrimination testing as of the last day of each cafeteria plan year, and there would be separate objective tests for both eligibility and contributions and benefits. Some of the concepts and special rules are drawn directly from qualified retirement plan nondiscrimination rules.
Employers should note that the contribution and benefits tests are intended to evaluate the actual election of benefits under a cafeteria plan by highly compensated participants. For example, a plan would be considered discriminatory if aggregate qualified benefits elected by highly paid participants exceeded the aggregate qualified benefits elected by the other participants. Benefits would be measured as a percentage of aggregate compensation for these groups.
Special nondiscrimination testing rules would apply to cafeteria plans used to provide health benefits and for premium-only plans.
Debit Card Programs
IRS rulings in recent years have gone a long way toward showing employers how they could take advantage of advances in electronic payment card programs while still complying with the cafeteria plan rules, especially those related to health flexible spending accounts, or FSAs.
To judge from these proposals, however, the IRS is concerned that employers have not been following its lead in this area. Most of the concern revolves around the requirement that health FSA expenses be verified or “substantiated” before participants can tap into their accounts. Debit card programs have attempted to replace the traditional, labor-intensive arrangements, such as filling out forms and sending in receipts.
Under the new proposals, health FSAs – or, more accurately, the outside vendors that administer them – would be required to take rigorous steps to substantiate expenses. This includes restricting the use of cards to health care providers, stores that have inventory control systems that meet certain standards, and certain drugstores and pharmacies.
Employers would also have to put in place strict procedures to remedy any reimbursements of improper expenses, including deactivating cards, demanding repayment, withholding amounts from compensation, and offsetting future FSA claims against the owed amounts.
The IRS expressly indicates that the new proposed rules will not extend the effective dates of its prior guidance, which included many of these features.
The proposed cafeteria plan rules also would:
- Modify the tax treatment of employer-provided group-term life insurance beyond $50,000 so that the Table 1 cost of such excess insurance (minus employee after-tax contributions) is included in gross income.
- Clarify that employers can properly retain FSA forfeitures or use them for plan purposes (such as offsetting administrative expenses).
- Expand on the requirement of a “written” document to include specific provisions such as: detailed descriptions of benefits, eligibility rules and the procedure for making election changes, and the manner in which employer contributions will be made.
- Clarify that a cafeteria plan can be used to pay or reimburse individual health insurance premiums.
- Require plans that allow salary reduction contributions to HSAs to specifically describe the HSA benefit, prospectively allow participants to change their election amounts at least monthly, and allow participants who become ineligible to prospectively revoke their HSA elections.
- Permit, though not require, health FSAs to allow reimbursements of orthodontia payments that participants must make before services are provided.
- Permit, though not require, dependent care FSAs to allow participants to use FSA funds to pay for dependent care expenses incurred after an employee terminates employment but before the end of the relevant plan year or grace period (note, though, that a plan would have to verify that the former employee was still satisfying all the conditions for dependent care under Code Section 129).
Note: This article was published in the August – December 2007 “Double Issue” of The Employment Law Authority.