NLRG PARTNERING WITH YOU ON TRENDS AND BEST PRACTICES TO SUPPORT YOUR HUMAN RESOURCES INITIATIVES CAFETERIA PLANS: AN EMPLOYER GUIDE

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1 NLRG PARTNERING WITH YOU ON TRENDS AND BEST PRACTICES TO SUPPORT YOUR HUMAN RESOURCES INITIATIVES CAFETERIA PLANS: AN EMPLOYER GUIDE

2 TABLE OF CONTENTS What is a Cafeteria Plan? 1 Are All Cafeteria Plans the Same? 1 Is a Plan Document Required? 1 What Information is Included in the Plan Document 2 What if There is No Plan Document? 3 What Actions Could Jeopardize a Cafeteria Plan? 3 What is a Cafeteria Plan s Plan Year? 3 Who Can Participate in a Cafeteria Plan? 3 Who is a Section 105(b) Dependent? 4 Who Can Not Participate in a Cafeteria Plan? 5 Are There Disclosure Requirements for a Cafeteria Plan? 6 Is the Cafeteria Plan Subject to ERISA? 6 Can a Cafeteria Plan Favor Highly Compensated Employees? 6 What Benefits Can a Cafeteria Plan Provide? 7 What Benefits Can a Cafeteria Plan Not Provide? 7 Individual Insurance Policies 8 How Are Cafeteria Plan Benefits Funded? 8 Employer Contributions and Affordability 9 How Do Employees Make Elections Under a Cafeteria Plan? 9 When Are Elections and Election Changes Effective? 10 Can Employees be Automatically Enrolled in a Cafeteria Plan? 10 Are Evergreen Elections Permitted? 10 Can New Hires Receive Benefits on a Retroactive Basis? 11 Can Employees Change their Pre-Tax Elections During the Year? 11 What Events Will Allow Employees to Change Their Elections? 11 IRS Expands Change In Election Rules 12 Does the Election Change Have to Be Consistent with the Event? 13

3 How Long Does the Employee Have to Make an Election Change? 14 How Are Election Changes Documented? 14 How Should FMLA Leave Be Administered Under the Cafeteria Plan? How are Benefits Paid During FMLA Leave? 15 Prepay Option 15 Pay-As-You-Go Option 16 Catch-Up Option 16 What Are the Reporting Requirements for a Cafeteria Plan? 17 DCSA Reporting 17 Form 5500 Filing 17 What is a Simple Cafeteria Plan? 17 What are the Requirements for a Simple Cafeteria Plan? 18 Eligibility and Participation Requirement 18 Minimum Contribution Requirement APPENDIX Glossary of Abbreviations 20 Cafeteria Plan Checklist 21 Change in Election Form 23 Non-Discrimination Testing Chart 27 Updated: July 2015 RELATED EMPLOYER GUIDE AND TOOLS ERISA Reporting: An Employer Guide ERISA Disclosure: An Employer Guide Spending Accounts: An Employer Guide

4 WHAT IS A CAFETERIA PLAN? Cafeteria plans provide a special exception to general federal income tax rules applicable to an employee s income. Cafeteria plans allow employees to select among a variety of nontaxable benefits and cash. Generally, this choice takes the form of allowing employees to purchase benefits, such as health insurance, with pretax dollars. This allows employees to have more take-home pay. Cafeteria plans are governed by Section 125 of the Internal Revenue Code (IRC). ARE ALL CAFETERIA PLANS THE SAME? While all cafeteria plans must meet certain requirements of Section 125, not all cafeteria plans are the same. The simplest form of cafeteria plan is a premium only plan. This type of cafeteria plan allows employees to pay for their share of premiums with pre-tax dollars. An employer can also combine the premium payment feature with a health care spending account (HCSA, also known as a health flexible spending account) and/or a dependent care spending account (DCSA). A HCSA is used to pay for certain medical expenses that are not reimbursed elsewhere. A DCSA is used to reimburse certain dependent care expenses, such as child care expenses, that allow the employee and his or her spouse to be gainfully employed. Additional information about spending accounts can be found in Spending Accounts: An Employer Guide. IS A PLAN DOCUMENT REQUIRED? A "cafeteria plan" must satisfy several conditions. Regulations are clear that any failure to operate in accordance with the terms of the plan or the requirements of Section 125 will disqualify the plan (it will not be a cafeteria plan) and result in gross income to participants. In other words, if the cafeteria plan fails to follow the rules anyone participating in the plan will lose the tax benefits he or she would have otherwise received. The first condition that the cafeteria plan must satisfy is that it must be established pursuant to a written plan instrument. The rules are clear that cafeteria plans, and any amendments to them, must be set out in writing. This document may or may not be an Employee Retirement Income Security Act of 1974 (ERISA) plan document, depending on the benefit options. For example, a cafeteria plan with a HCSA will be subject to ERISA, but other cafeteria plans will not be. If the plan is subject to ERISA, it must satisfy the ERISA disclosure and reporting obligations (e.g., summary plan descriptions). Even if the cafeteria plan is not subject to ERISA, the component benefit options may be ERISA plans. Whether subject to ERISA or not, a cafeteria plan document must describe plan terms, election rules, and plan administration procedures. These provisions generally will constitute the "contract" between employer/plan sponsor and the employees. In addition, the IRS will examine the plan document in the event of an audit. This plan document must describe the maximum amount of employer contributions available to any individual by stating the maximum amount of elective contributions available to any employee under the plan. The term "elective contributions" refers to amounts contributed to a cafeteria plan through salary reduction. For this purpose, the plan may state the maximum as a flat dollar amount or a percentage of CAFETERIA PLAN EMPLOYER GUIDE 1

5 compensation, or the plan may simply state the method used to determine the maximum dollar or percentage limit. The cafeteria plan must be adopted and effective on or before the first day of the plan year to which it relates. Any amendments to the cafeteria plan can only be effective for periods after the later of the adoption date or the effective date of the amendment. The terms of the plan must apply uniformly to all participants. The plan document may be comprised of multiple documents. Tip: While there are many decisions that must be made when setting up a cafeteria plan, the following are the basic steps: 1. Decide on the design features of the cafeteria plan such as eligibility, which premiums can be paid on a pre-tax basis, will employees receive cash if they waive benefits, etc. 2. If there will be a HCSA or DCSA, decide who will administer the benefits (e.g., pay claims, etc.). 3. Prepare plan documents. 4. Adopt the plan through board resolution (adoption of a cafeteria plan generally requires the same kind of documentation that an entity uses for other major business actions). 5. Distribute communication materials to employees. 6. Obtain employee elections. 7. Set up payroll to take pre-tax elections. WHAT INFORMATION IS INCLUDED IN THE PLAN DOCUMENT? According to the regulations, a cafeteria plan document must contain the following information: A specific description of each of the benefits available through the plan as well as the periods of coverage (the periods during which the benefits are provided); The plan s rules governing participation; The procedures governing employees elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective, and providing that elections are irrevocable (except to the extent that the change in status rules (as discussed below) are included in the plan); The manner in which employer contributions may be made under the plan; The maximum amount of employer contributions available to any employee through the plan. This is accomplished by stating the maximum amount of salary reduction (elective) contributions available under the plan, and, if the cafeteria plan permits contributions to 401(k) plans, the maximum amount of elective deferrals available. The plan year; If the plan offers paid time off, the required ordering rule for the use of non-elective and elective paid time off; CAFETERIA PLAN EMPLOYER GUIDE 2

6 If the plan includes HCSAs, a grace period, or distributions from a HCSA to employees Health Savings Accounts (HSAs), the plan s provisions complying with the specific requirements of those benefits. WHAT IF THERE IS NO PLAN DOCUMENT? The Internal Revenue Service (IRS) has always characterized pre-tax deductions from income in the absence of a cafeteria plan document as impermissible and the regulations make this abundantly clear. Without a plan document, the IRS takes the position that the employer has under-withheld the taxes for participating employees. Such under-withholding could lead to payroll tax underpayment and IRS penalties. The rules provide that if there is no cafeteria plan document, if the document does not satisfy each of the plan document requirements, or if the plan fails to operate in accordance with the terms of the plan or Section 125 rules, the plan is not a cafeteria plan and an employee s election between taxable and nontaxable benefits results in gross income to the employee. WHAT ACTIONS COULD JEOPARDIZE A CAFETERIA PLAN? If the plan fails to operate in accordance with the terms of the plan or Section 125 rules, known as an operational failure, then it could jeopardize the cafeteria plan s preferential tax treatment. Examples of operational failure include, but are not limited to: Offering benefits under the plan other than those permitted; Operating to defer compensation; Allowing employees to revoke or make new elections, except as provided under the rules and/or terms of the plan; Reimbursing ineligible expenses in a HCSA or DCSA; or Failing to comply with the substantiation requirements for a HCSA or DCSA. WHAT IS A CAFETERIA PLAN S PLAN YEAR? The plan document must specify the plan year and the plan year must be twelve consecutive months, unless there is a short plan year (i.e., a plan year that is less than 12 months). The plan year can begin on any day of any calendar month but, if the plan year is not the calendar year, it must end on the preceding day in the immediately following year. The plan year can be changed and a short plan year of less than twelve consecutive months is permitted but only for a valid business purpose. Usually, the plan year is the coverage period for benefits provided through the cafeteria to which annual elections for these benefits apply. WHO CAN PARTICIPATE IN A CAFETERIA PLAN? All individuals eligible to participate in a cafeteria plan must be employees. Although former employees may participate, a cafeteria plan may not be established or maintained predominantly for the benefit of former employees. CAFETERIA PLAN EMPLOYER GUIDE 3

7 In all cases where the employee is actually participating in the cafeteria plan, spouses and other family members can be provided tax-favored qualified benefits under the cafeteria plan if they meet certain tax code requirements and also meet the plan s dependent eligibility requirements. Individuals who are identified in IRC Section 105(b) are eligible for nontaxable health benefits. The individuals identified in Section 105(b) include the employee, of course, and the employee s spouse. Those individuals also include, for a calendar year, any of the employee s children who will have not attained age 27 by the end of the year, as well as any of the employee s Section 105(b) dependents. Note: Per Revenue Ruling , the term spouse, as used in this Employer Guide, includes an individual married to a person of the same sex if the couple is lawfully married under state law. Under the ruling, the IRS will treat two same-sex individuals as one another s spouses if their marriage was legal in the state, territory or foreign country where it occurred even if they live in a state that does not recognize same-sex marriages. For a same-sex marriage to be recognized, it must have occurred in a state, territory or foreign country that authorized same-sex marriages at the time. Couples that have entered into other similar relationships (e.g., domestic partnerships and civil unions) will not be treated as spouses for federal tax purposes. While these individuals may receive cafeteria plan benefits as plan beneficiaries, they do not have election rights (they may not choose the benefits or change elections). The spouse or dependents of employees may not be participants in a cafeteria plan unless they are also employees. WHO IS A SECTION 105(B) DEPENDENT? This group includes any individuals that an employee can claim as dependents on an income tax return plus a few individuals who do not qualify as tax dependents for reasons specified in Section 105(b). Applying the Section 105(b) modifications to the definition of tax dependent results in a Section 105(b) dependent being anyone who is either a Section 105(b) child or a Section 105(b) relative. An individual generally is an employee s Section 105(b) child for the year if ALL SIX of the following requirements are met: 1. The individual is the employee s child, sibling or step-sibling, or is a descendant of the employee s child, sibling or step-sibling An employee s child is the son, daughter, stepson or stepdaughter of the employee, with these children including both legally adopted children and children placed for adoption. A child also includes an eligible foster child, defined as an individual who is placed with the employee by an authorized placement agency or by judgment, decree or other order of any court of competent jurisdiction. 2. The individual has the same principal abode as the employee for more than one-half of the year 3. At the end of the year, the individual is less than 19 years old (24, if a student ) or is permanently disabled CAFETERIA PLAN EMPLOYER GUIDE 4

8 Tip: A student must be full-time for at least 5 calendar months or pursuing full-time onfarm training under prescribed supervision. 4. The individual does not provide more than one-half of his or her own support for the year 5. The individual has not filed a joint tax return (other than for a refund claim) with his or her spouse for the year 6. The individual is a citizen or national of the United States, or a resident of the United States or of a country contiguous to the United States Tip: A special residency/citizenship rule applies to a child who has been legally adopted or lawfully placed for adoption. An individual is not a qualifying child of any other taxpayer if the individual s parent (or other person with respect to whom the individual is defined as a qualifying child) is not required by section 6012 to file an income tax return and (i) does not file an income tax return, or (ii) files an income tax return solely to obtain a refund of withheld income taxes. An individual generally is an employee s Section 105(b) relative if ALL FOUR of the following requirements are met: 1. The individual is the employee s relative by either blood or marriage, or has the same principal abode as the employee and is a member of the employee s household for the tax year. An employee s relative is any of the following: (1) the employee s child, stepchild, foster child or descendant of any of these; (2) the employee s brother, sister, stepbrother or stepsister; (3) the employee s father or mother, or an ancestor of either; (4) the employee s stepfather or stepmother; (5) the son or daughter of the employee s brother or sister; (6) the brother or sister of the employee s father or mother; (7) the employee s son-in-law, daughter-in-law, father-inlaw, mother-in-law, brother-in-law, or sister-in-law. 2. The employee provides over one-half of the individual s support for the year. 3. The individual is not, for the taxable year, anyone s qualifying child as defined above. 4. The individual is a citizen or national of the United States, or a resident of the United States or of a country contiguous to the United States. WHO CAN NOT PARTICIPATE IN A CAFETERIA PLAN? Independent contractors, sole proprietors, partners, non-employee directors (those solely serving on a corporation s board of directors), and those owning more than two percent of an S corporation are considered self-employed, and they may not participate in a Section 125 plan. In some cases, self-employed individuals family members are also ineligible due to ownership attribution rules, even if the family members are also employees of the employer. Of course, the businesses owned by these self-employed persons can maintain a cafeteria plan for their employees. CAFETERIA PLAN EMPLOYER GUIDE 5

9 ARE THERE DISCLOSURE REQUIREMENTS FOR A CAFETERIA PLAN? The IRC does not impose specific requirements as to what information must be disclosed to participants. ERISA disclosure rules (which would require a summary plan description or a summary of material modifications) do not apply to premium only plans or DCSAs (although the rules that apply to DCSAs require that [r]easonable notification of the availability and terms of the program shall be provided to eligible employees. ) Other benefits offered under the cafeteria plan may also be subject to ERISA. For example, a HCSA is generally subject to ERISA requirements. IS THE CAFETERIA PLAN SUBJECT TO ERISA? A stand-alone premium only cafeteria plan is not an ERISA welfare plan. However, since employee contributions to a premium-only cafeteria plan are considered contributions to the underlying medical or other ERISA plan they are deemed ERISA "plan assets." The contributions become plan assets "as of the earliest date on which such contributions can reasonably be segregated from the employer s general assets." According to Department of Labor (DOL) regulations, this time period is a maximum of 90 days. However, the DOL mandates a shorter period if it can be demonstrated that an employer's payroll system is able to segregate contributions more quickly. Once contributions become plan assets, all persons who have discretion or control over the contributions are subject to the fiduciary standards of ERISA with respect to those amounts. In applying the ERISA fiduciary standards, however, the DOL recognizes the special status of cafeteria plans, and provides a policy of non-enforcement as to one fiduciary obligation (holding plan assets in trust) and certain ERISA reporting requirements. Under the policy, the DOL will not assert a violation, or assess a civil penalty, solely because of failure to hold participant contributions in trust or to comply with certain ERISA reporting requirements for plans receiving participant contributions. CAN A CAFETERIA PLAN FAVOR HIGHLY COMPENSATED EMPLOYEES? A cafeteria plan must meet certain nondiscrimination requirements to maintain its tax-advantaged features. A plan sponsor needs to assure that the cafeteria plan is not discriminatory in favor of key employees and/or highly-compensated employees. Discrimination generally will not jeopardize Section 125 plan status; although egregious violations might cause a plan to be "disqualified." In most cases discrimination problems usually cause only the value of taxable plan benefits to become taxable income to the affected key or highly-compensated employees still a very unpopular result. Discrimination also could cause employee relations problems at all levels. The plan must generally meet the following three nondiscrimination requirements: 1. The cafeteria plan must not discriminate in favor of highly compensated individuals as to ability to participate; 2. The cafeteria plan must not discriminate in favor of highly compensation participants as to contributions or benefits paid; and 3. Contributions under the cafeteria plan must satisfy a concentration test that looks at the contributions made by key employees. CAFETERIA PLAN EMPLOYER GUIDE 6

10 A cafeteria plan must meet all of these tests to avoid creating taxable income for highly compensated employees. WHAT BENEFITS CAN A CAFETERIA PLAN PROVIDE? Only qualified benefits can be offered under a cafeteria plan. A benefit will be a "qualified benefit" for purposes of Section 125 of the IRC if: The benefit (with an important exception) does not defer the receipt of compensation; and The benefit is excludable from gross income by reason of one of several specified IRC sections. Qualified benefits include: Health plans (including HCSAs) (IRC Sections 105 and 106) Disability income plans (including long-term disability and short-term disability) (IRC Sections 105 and 106) Accident plans (including accidental death and dismemberment) and business travel and accident plans (IRC Sections 105 and 106) Dependent care assistance (IRC Section 129) Group-term life insurance (IRC Section 79) Section 401(k) plan contributions (an exception to the rule on no deferral of income). Paid time off buy and sell plans Adoption assistance plans Premiums for COBRA continuation coverage (if excludible under Section 106) under the accident and health plan of the employer sponsoring the cafeteria plan or premiums for COBRA continuation coverage of an employee of the employer sponsoring the cafeteria plan under an accident and health plan sponsored by a different employer Contributions to Health Savings Accounts (HSAs) Tip: Paying premiums for disability plans on a pre-tax basis will result in the benefits received being subject to income tax. Tip: Section 79 allows an employer to provide each of its employees up to $50,000 in tax-free term life insurance coverage. Group life insurance is a qualified benefit even if the total coverage amount exceeds $50,000. Group-term life insurance that is combined with permanent benefits cannot be included in a cafeteria plan. Employers must consider imputed income issues for amounts over $50,000 when all or a portion of the insurance is provided through a cafeteria plan. WHAT BENEFITS CAN A CAFETERIA PLAN NOT PROVIDE? Regardless of whether such benefits are purchased with after-tax employee contributions, the following benefits are nonqualified benefits and may not be offered in a cafeteria plan: Archer medical savings accounts (IRC Section 220) Group term life insurance on the life of any individual other than the employee (e.g. employerprovided dependent life insurance benefits) CAFETERIA PLAN EMPLOYER GUIDE 7

11 Benefits under qualified tuition reduction programs (IRC Section 117) Educational assistance programs (IRC Section 127) Certain fringe benefits (IRC Section 132) Elective deferrals to Section 403(b) plans Long-term care insurance or services Employer-provided meals and lodging (Section 119) Health reimbursement arrangements (HRAs) that provide reimbursements up to a maximum dollar amount for a coverage period and that all or any unused amount at the end of the period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods INDIVIDUAL INSURANCE POLICIES IRS Notice and accompanying Q&A and other guidance make clear the agency s position that arrangements designed to fund the purchase of individual insurance policies with pre-tax employee contributions via a cafeteria plan or tax-preferred reimbursement with employer contributions are not permitted on or after the first day of the 2014 plan year. The Department of Labor (DOL) has issued comparable guidance in the form of technical release Affected by this guidance is any employer-based arrangement that facilitates the payment or reimbursement of premiums for individual coverage, named employer payment plans, regardless of: Whether the arrangement pays the premium directly to the carrier or reimburses the individual, Whether the arrangement pays or reimburses other expenses, and Whether or not the individual coverage is part of a public exchange. Also affected by this guidance would be any defined contribution reimbursement arrangements such as HRAs and health care spending accounts (HCSAs). The agencies advised that an employer payment arrangement (whether an ERISA plan or not) which reimburses employees for the cost of an individual health insurance policy or other form of health coverage (either purchased through the Marketplace or obtained outside of the exchanges) fails to satisfy PPACA market reforms, regardless of whether: The employer contributions are provided by operation of a cafeteria plan or outside of a cafeteria plan; or The contributions are made on a pre-tax or a post-tax basis. HOW ARE CAFETERIA PLAN BENEFITS FUNDED? Under IRC Section 125, participants may make an election between benefits and otherwise taxable compensation. While the cost of coverage is typically paid by employees through salary reductions, employers are permitted to contribute to the cost of benefits. Employees may reduce salary on a pre-tax basis (i.e., salary reduction) or be permitted to contribute aftertax dollars (i.e., payroll deduction) to pay for benefits. Employers may offer participants credits or contributions toward the purchase of cafeteria plan benefits. The employer contributions can take a variety of forms such as a match on employee contributions or as seed money. They may also be discretionary credits allocated by employees toward elected benefits or, in some cases, cashed out. Finally, an employer may make additional contributions for employees who forgo certain core benefits. These contributions can CAFETERIA PLAN EMPLOYER GUIDE 8

12 be used to fund other benefits and in some cases may also be received as additional taxable compensation. Employers may utilize one or more of these funding mechanisms to achieve the desired result. EMPLOYER CONTRIBUTIONS AND AFFORDABILITY Under PPACA individual mandate requirements, an employee is exempt from having to obtain minimum essential coverage or pay a penalty if the cost of the employee s employer-sponsored health coverage exceeds 8% of the employee s household income (subject to indexing), based on the lowest cost self-only coverage for the employee and the lowest cost family coverage for the employee s spouse and dependents. The IRS has issued guidance that addresses how certain collateral employer contributions to employee health benefits affect the affordability of an employee s health plan contributions for individual mandate purposes. If an employer contributes to a cafeteria plan, the amount of those contributions is viewed as lowering the amount of the employee s contribution to the employee s health coverage under the employer s primary health plan for purposes of determining the affordability of that coverage, if: The employee cannot take those employer contributions as a taxable benefit (either as cash or a benefit provided under the cafeteria plan that is taxable to the employee); The employer contributions may be used by the employee to purchase MEC; and The employee may only use the employer contributions to pay for medical care (within the meaning of IRC Section 213). In the view of the IRS, if an employee s nontaxable employer contributions to a cafeteria plan are not limited to medical expenses, it cannot be assumed that the employee will use those contributions to purchase minimum essential coverage. The IRS guidance was specific to the affordability requirements for purposes of the individual mandate. The regulations do not address how employer contributions that an employee may elect to use for health coverage are treated under the employer shared responsibility provisions. In order to avoid penalties under health care reform s employer shared responsibility provisions, applicable large employers (i.e., those with 50 or more fulltime employees, including full-time equivalent employees, during the preceding year) must offer minimum essential coverage that is of minimum value and affordable. Coverage is deemed affordable for an employee if the employee s required contribution does not exceed 9.5% (subject to indexing adjustments) of the employee s household income. HOW DO EMPLOYEES MAKE ELECTIONS UNDER A CAFETERIA PLAN? To be a cafeteria plan, employees must be permitted to make elections for the plan year among the permitted taxable benefits and qualified benefits offered under the plan. Elections must be made before the earlier of the date when the taxable benefits are currently available to the employee or the first day of the plan year. Subject to certain exceptions, such annual elections are irrevocable for the plan year. These exceptions are discussed in more detail below. Elections are not required to be in writing. Under the rules, new elections and election changes may be made electronically (e.g. via the telephone or computer). The rules under which pension plans must administer certain electronic notices and elections (Treas. Reg. Section 1.401(a)-21) apply to cafeteria plans as a safe harbor for valid electronic cafeteria plan elections. CAFETERIA PLAN EMPLOYER GUIDE 9

13 WHEN ARE ELECTIONS AND ELECTION CHANGES EFFECTIVE? The plan document must address the timing of participant elections and when they are effective. Employees may never make Code Section 125 plan elections that defer compensation already earned. In other words, cafeteria plan elections may never take effect retroactively. The same cafeteria plan rules apply for mid-year election changes. Retroactive elections (and election changes) are generally not permissible except for certain new hires (explained below) and the retroactive special enrollment right under HIPAA that applies to a child s birth, adoption, or placement for adoption. For example, if an employee has a baby and returns an election form within 30 days, coverage will be effective back to the baby s date of birth (although contributions for the coverage will only take effect for payroll periods after an election form is received and processed by HR). The rules do not specify as to when a requested election change must be effective but due to the general prohibition on retroactive elections, unless there is a special exception (such as for medical coverage of a new born baby under HIPAA) the election change will be effective as soon as the election form is received and processed by HR. CAN EMPLOYEES BE AUTOMATICALLY ENROLLED IN A CAFETERIA PLAN? The IRS first officially approved automatic enrollment procedures (e.g. default elections) for cafeteria plans in Revenue Ruling The proposed regulations confirm that default elections are permissible (but not required). It is permissible for an employer plan to automatically provide each employee with employee-only coverage under Section 125 as long as the employee has the choice to take the coverage or opt out of coverage and receive taxable cash in lieu of the benefit. Employers who use this type of election method must provide adequate notice to employees. The procedures include providing employees with notice at the time of hire and before the beginning of each plan year with: An explanation of the plan s automatic enrollment process and the employee s right to decline coverage; The amounts that will be reduced from the employee s salary; An explanation about how employees can decline coverage; Information about when elections must be made; The effective period for elections; and An explanation of the employee s existing coverage, if any. ARE EVERGREEN ELECTIONS PERMITTED? The proposed regulations also confirm that automatic or evergreen elections are permitted. These are elections that continue from plan year to plan year unless the employee makes an election to not participate CAFETERIA PLAN EMPLOYER GUIDE 10

14 in the plan (or to change his or her current election). Open enrollment materials must be distributed each year to all participants and the use of evergreen elections should be disclosed to participants (in the plan summary, in open enrollment materials, etc.). CAN NEW HIRES RECEIVE BENEFITS ON A RETROACTIVE BASIS? Generally, elections and election changes must be made on a prospective basis (meaning that the election must be made before the first day of the coverage period (e.g., plan year) for which the benefits are to be provided). An exception exists for elections or election changes due to birth, adoption, or placement for adoption. The regulations also allow retroactive coverage for new hires. A cafeteria plan can give new hires a 30-day grace period following their date of hire to make an election under the cafeteria plan. This rule does not extend to rehires or employees who are newly eligible. Although the election can be effective as of the employee s date of hire, pre-tax deductions for that coverage cannot be effective with respect to compensation that is available on the date of the election (salary reductions to pay for elected benefits must be taken from compensation that is not yet currently available when the election is made). CAN EMPLOYEES CHANGE THEIR PRE-TAX ELECTIONS DURING THE YEAR? In general, an employee s election for the year is irrevocable. However, an employee may be eligible to make a mid-year change in election upon the occurrence of certain qualifying events. The IRS does not require any plan sponsor to allow cafeteria plan election revocations. Instead, plan sponsors are permitted to adopt cafeteria plan provisions that allow changes. The employer is free to disregard some change-instatus events. The employer also can impose stricter consistency requirements, or it can disallow certain election changes. Many employers wish to allow all of the changes that the IRS permits to give participants the maximum available flexibility. Other employers prefer to only allow legally-mandated election changes to simplify plan administration. The plan document should specify which qualifying events it will recognize and should be consulted when questions arise. WHAT EVENTS WILL ALLOW EMPLOYEES TO CHANGE THEIR ELECTIONS? The following are qualifying events that may allow an employee to change his or her election mid-year: 1. Change in employee s legal marital status (e.g., marriage, divorce, death of spouse, etc.) 2. Change in number of employee s dependents (e.g., birth, adoption, or placement for adoption of a child of the employee) 3. A dependent satisfies or ceases to satisfy the dependent eligibility requirements (e.g., due to attainment of age, student status, or any similar circumstance). For purposes of a dependent care election, this would include a change in the number of dependents whose care can be reimbursed on a tax-favored basis 4. Change in employment status of the employee, spouse or dependent (e.g., termination or commencement of employment, strike or lockout, change in worksite, commencement or return from an unpaid leave of absence) 5. Change in residence of employee, spouse or dependent 6. Reduction in hours (see details below) CAFETERIA PLAN EMPLOYER GUIDE 11

15 7. Enrollment in Marketplace/Exchanges (see details below) 8. COBRA qualifying events 9. With respect to adoption assistance elections (provided through a cafeteria plan), the start or ending of an adoption proceeding. 10. Change in cost that results in automatic increases/decreases in elective contributions 11. A significant change in cost Tip: A pay cut does not trigger the change in cost rules. 12. The addition or significant improvement of a benefit package option 13. A coverage change made under the plan of another employer (e.g., an election change made during the open enrollment of an employee s spouse) 14. A change in an employee s, spouse s or dependent s entitlement (gain or loss) for Medicare or Medicaid 15. A loss of group health coverage sponsored by a governmental or educational institution 16. Significant coverage curtailment (overall reduction), with or without a loss of coverage 17. HIPAA Special Enrollment Rights 18. Judgments, decrees or orders (including Qualified Medical Child Support Order) resulting from divorce, legal separation, annulment or change in legal custody 19. FMLA leaves of absence (k) election changes (a cafeteria plan can permit a participant to modify or revoke an election of contributions under a qualified cash or deferred arrangement as permitted or required under the terms of the Section 401(k) plan) Tip: No mid-year election change should be allowed due to a change-in-status unless the employer can answer "yes" to three questions: Has a change-in-status event occurred? Did that change-in-status event affect the eligibility of the employee, spouse, or dependent for an employer s plan? (In the case of a dependent care election: did that change-in-status event affect the employee s dependent care expenses that meet IRS requirements for tax-favored treatment? In the case of an adoption assistance election: did that change-in-status event affect the employee s adoption expenses that meet IRS requirements for tax-favored treatment?) Is the election change the employee is requesting on account of and corresponding with the change-in-status event? For specific information on what changes can be made (and how the rules apply to certain benefits), please see the "Mid-Year Election Change Chart" located on Willis Essentials. IRS EXPANDS CHANGE IN ELECTION RULES In Notice , the IRS expands upon the events that will allow an employee to change his or her pretax elections. Note that the guidance below does NOT impact health flexible spending account elections. The rules were expanded to allow participants to revoke their pre-tax elections due to a reduction in hours and due to enrollment in the Marketplace/Exchange. CAFETERIA PLAN EMPLOYER GUIDE 12

16 Reduction in hours. If an employee had been reasonably expected to average at least 30 hours of service per week, but there was a later change in the employee s status so that the employee actually averages fewer than 30 hours of service per week, then, even if the reduction does not result in the employee ceasing to be eligible under the group health plan, the employee may revoke coverage. The revocation is only permitted if the individuals losing coverage because of the revocation receive coverage under another plan that provides minimum essential coverage, and the new coverage must be in place by the first day of the second month following the month in which the prior coverage is revoked. The cafeteria plan may rely on the employee s reasonable representation that he or she (and any related individuals who are revoking coverage) has enrolled or will enroll in another health plan that provides minimum essential coverage within the required timeframe. Enrollment in the Marketplace/Exchange. If an employee qualifies for a Special Enrollment Period to enroll in the Marketplace/Exchange, OR if an employee chooses to enroll in the Marketplace/Exchange during the Exchange s annual open enrollment, then the group health plan coverage may be revoked for the employee and his/her dependents, and the individual(s) may enroll in the Marketplace/Exchange and may choose coverage that is effective no later than the day immediately following the last day of the prior coverage that was revoked. A cafeteria plan may rely on the employee s reasonable representation that the employee and any related individuals who are revoking coverage have enrolled or will enroll in coverage through the Marketplace within the required timeframe. This guidance was effective on September 18, 2014 and applies on a prospective basis to revocations of coverage after September 18, 2014 (plan sponsors may not permit employees to retroactively revoke coverage). Employers choosing to broaden their cafeteria plan change-in-election rules must amend their existing cafeteria plan documents to allow the above flexibility. The guidance provides for a special window of opportunity that allows implementation of this guidance in 2014 as long as the cafeteria plan is amended on/before the last day of the plan year that begins in After 2015, the amendment must be adopted on/before the last day of the plan year in which the changed elections are permitted, and the plan amendment may be effective retroactively to the first day of the plan year. As always, employers must inform plan participants of this plan change. DOES THE ELECTION CHANGE HAVE TO BE CONSISTENT WITH THE EVENT? Any changes in election must be consistent with, and on account of, the qualifying event. For example, if an employee has family coverage under the medical plan and later has a baby, dropping from family to employee-only coverage would not be consistent with the addition of a dependent. The on account of requirement is intended to address the timing of an election change; a request to make a new election six months after the birth of a child would not be on account of that change in status. All changes must be as a result of the qualifying event. Example A: An employee has family coverage for himself, his spouse, and his dependent under the medical plan. Dependent children are eligible under the medical plan until they turn age 26. Under this scenario, a change in status occurs when the child turns age 26. A prompt change from family to employee plus spouse coverage is consistent with and on account of the change in status because the dependent is no longer eligible to be covered under the plan. However, if the dependent turns age 26 in May, a change in election in October would be too long after the date of the event to be considered on account of the change in status. Additionally, had the dependent CAFETERIA PLAN EMPLOYER GUIDE 13

17 not been covered under the medical plan when eligible, his turning age 26 would not have been a qualifying event that would allow the employee to make an election change. Example B: An employer offers the choice between a medical PPO or indemnity plan. An employee is currently enrolled in the PPO. If the employer adds an HMO option, a change in coverage will occur to the employee. A prompt change in coverage to the new HMO is consistent with and on account of such coverage change. However, a change from the PPO to the indemnity plan would not be consistent with the addition of the HMO. The plan administrator has discretion in determining whether a qualifying event has occurred, and the extent to which an election change is permissible, consistent with Code Section 125. HOW LONG DOES THE EMPLOYEE HAVE TO MAKE AN ELECTION CHANGE? The rules do not address how long a participant has after a permitted event to request a change of election. However, in order to comply with the on account of and consistent with rules the election request should not be too far removed from the event. The amount of time a participant has to submit an election change request should be addressed in the plan document. Tip: Many plans give participants 30 or 31 days to submit an election change request. HOW ARE ELECTION CHANGES DOCUMENTED? IRS regulations do not address what kind of documentation employers must maintain to substantiate election adjustments. For many plans, the participant merely fills out a "change form" indicating the reason for the change, with no attached documentation at all. Other plans require the same type of proof that an insurance carrier might request: marriage certificate, birth certificate, divorce decree, death certificate, or other written proof. Because the law does not specify what constitutes acceptable proof, plan sponsors have some latitude to establish policies on acceptable proof for plan purposes. At a minimum, plan sponsors should require that appropriate plan forms are completed and signed whenever a request is made to change a Section 125 election. The form should briefly describe the situation and require the employee s signature attesting to the accuracy of the event. The plan sponsor might also require that documentation be attached to the form (for example, a marriage certificate) depending on the event. The plan sponsor, of course, must treat all participants in a uniform fashion and, for each type of event, should require the same documentation from each person who submits a status change request based on that event. The IRS does examine documentation of election changes in cafeteria plan audits. A sample Cafeteria Plan Change in Election Form is included in the Appendix. HOW SHOULD FMLA LEAVE BE ADMINISTERED UNDER THE CAFETERIA PLAN? CAFETERIA PLAN EMPLOYER GUIDE 14

18 When a participant is on an unpaid leave of absence, like the Family Medical Leave Act (FMLA), there is no longer a way for the employer to collect employee contributions for the benefit plans or spending accounts. However, under FMLA employers must allow the employee to maintain coverage. A basic tenet of cafeteria plans is the irrevocability of plan elections. As discussed above, the IRS does recognize exceptions to this rule and will permit revocations due to certain changes-in-status. The IRS FMLA regulations recognize, however, that the FMLA gives employees taking unpaid FMLA leave an independent right to revoke their elections (distinct from any change-in-status), as well as a right to reinstatement of their elections upon returning from FMLA leave. (Employees taking paid FMLA leave do not have this independent right to revoke their elections or discontinue health coverage during FMLA leave.) The rules allow an employer to choose between: (1) offering employees taking unpaid FMLA leave the option to discontinue their health coverage during the leave, and (2) requiring employees taking unpaid FMLA leave to continue receiving health coverage during the leave, but offering such employees the option to discontinue making any contributions during the leave and pay required premiums upon returning from the leave. If the employees terminate plan participation at any time during the FMLA period, the employer can require the employees to reinstate their health coverage upon return from FMLA leave, provided employees returning from non-fmla leave are also required to resume participation upon their return. HOW ARE BENEFITS PAID DURING FMLA LEAVE? IRS regulations contain rules governing arrangements for payment of health insurance costs while an employee is on unpaid FMLA leave. (These payment regulations do not apply in situations where the employee takes paid FMLA leave. During paid leave, the employee s share of the premiums would be paid by the method normally used during any other paid leave.) The regulations authorize three methods for employees who are making premium payments under a cafeteria plan to make their required contributions while on unpaid leave. A cafeteria plan may, on a nondiscriminatory basis, offer up to three payment options. For more information on FMLA, please see FMLA Administration: Employer Guide available on Willis Essentials. PREPAY OPTION Under the prepay option, a cafeteria plan may permit an employee to pay, prior to commencement of the FMLA leave period, the amounts that will be due for coverage during the FMLA leave period. The IRS warns that under the DOL s FMLA regulations, employers may not mandate that employees prepay the amounts due for the leave period. The regulations also indicate that the prepay option can never be the only option available to employees on FMLA leave. Contributions under the prepay option may be made, for any portion of the leave that will be completed in the then-current cafeteria plan year, on a pretax salary reduction basis from any taxable compensation. As an example of taxable compensation, the IRS cites the "cashing-out" of unused sick pay or vacation time CAFETERIA PLAN EMPLOYER GUIDE 15

19 (when permitted by the employer) as an appropriate way to fund the prepayment of group health plan premiums or health care spending account contributions. The rules also permit the prepayment of these amounts on an after-tax basis. Employees may not use the prepay option for leave periods extending into another plan year. This would be a violation of the deferred compensation rule. The IRS regulations address what happens when an employee s FMLA leave covers parts of two different plan years. In that situation, the cafeteria plan cannot operate in a way that would enable employees to defer compensation from one cafeteria plan year to the next. Example: An employee, Adam, elects health coverage under a calendar year cafeteria plan. Adam s premium for health coverage is $100-per-month. Adam takes 12 weeks of FMLA leave commencing on October 31 (after already paying 10 months of premiums, or $1,000). Adam chooses to use the "prepay" method of paying for his coverage during the leave by cashing in his unused sick days. Under the prepay method, Adam may prepay the premiums due in November and December on a pretax basis, but Adam would not be allowed to prepay his January payment in the same way. If allowed to do so, he would be deferring compensation into the next cafeteria plan year. If Adam chooses to participate in the cafeteria plan for the next year, he must use either the pay-as-you-go or catch-up option to pay premiums for January. PAY-AS-YOU-GO OPTION Under the "pay-as-you-go" option, an employee on FMLA leave may pay his share of the premium payments on the same schedule as payments would ordinarily be made if the employee were not on leave. The IRS regulations also approve of other payment schedules permitted by FMLA regulations (such as payment schedules for COBRA participants). An employer also may use premium payment schedules already in place that govern contributions by employees in unpaid leave situations, and any other system voluntarily established between the employer and employee that is consistent with applicable regulations. Contributions under the pay-as-you-go system generally are made by the employee on an after-tax basis. However, pretax payments are permitted to the extent that the contributions are made from taxable compensation that is payable to the employee during the leave period (such as sick pay or vacation pay), and provided all cafeteria plan requirements are satisfied. If the pay-as-you-go option is offered to employees on non-fmla unpaid leave, a cafeteria plan cannot offer employees on FMLA leave a choice of either the prepay option or the catch-up option without also offering the pay-as-you-go option. Example: A participant has a baby on July 1. Under FMLA she is entitled to 12 weeks of unpaid leave. She is enrolled in the medical plan and contributes $100 per month. If she is on leave for July, August and September, she will have a total of $300 due. She may either send in a check each month for $100, or she may have her employer withhold all $300 from her last paycheck in June. CATCH-UP OPTION The catch-up option generally applies to two situations. First, an employee may elect to use this alternative to fund his cafeteria plan payments while on FMLA leave. Second, the employer may use this method to recoup premium payments it has made on behalf of the employee. CAFETERIA PLAN EMPLOYER GUIDE 16

20 Under the catch-up option, the employer assumes responsibility for advancing payment of the premium on the employee s behalf during the FMLA leave with the mutual understanding that advanced amounts must be repaid by the employee when he returns from the FMLA leave. An employer also may use the catch-up method to recoup payments advanced without the employee s express consent. The IRS regulations reiterate that an employer is not required to continue the health coverage of an employee who fails to make the required premium payments while on FMLA leave. Yet, an employer must reinstate an employee to exactly the same level of benefits he had prior to FMLA leave. An employer may find itself caught in the difficult position of persuading an insurance carrier to restore coverage to original levels after a lapse in coverage. As a result, an employer will often pay for the continuation of benefits during the leave period when an employee fails to make required contributions. The catch-up option may be the sole choice offered to employees on FMLA leave if it is the only payment arrangement an employer offers to employees in any unpaid leave situation. Contributions under the catchup option may be made on a pretax, salary reduction basis when the employee returns from FMLA leave. Contributions under the catch-up option also may be made on an after-tax basis. The regulations also permit employers to voluntarily waive, on a nondiscriminatory basis, the requirement that employees who elect to continue health coverage while on FMLA leave pay the amounts the employees would otherwise be required to pay for coverage during the leave period. WHAT ARE THE REPORTING REQUIREMENTS FOR A CAFETERIA PLAN? DCSA REPORTING The Plan Administrator shall furnish to each participant on or before January 31 each year a written statement showing the amounts paid to the participant during the previous calendar year. In addition, employee s DCSA contributions must be reported on Section 10 of the W-2 Form. FORM 5500 FILING IRS Notice indefinitely suspended the requirement to file the Schedule F along with the Form The Schedule F had long been an IRS filing obligation for cafeteria plans, adoption assistance programs and educational assistance plans. That means that cafeteria plans, along with educational and adoption assistance plans, do not have a direct filing obligation (not since April 4, 2002). Plan sponsors should note that, even though the IRS filing requirement for cafeteria plans has been eliminated, the DOL requirement for welfare benefits plans remains in place. In other words, plan sponsors must still file the Form 5500 for any welfare benefit plans that they offer (e.g., medical (including HCSAs), dental, life insurance, disability, and vision plans), unless their plan qualifies for a DOL-recognized filing exemption. WHAT IS A SIMPLE CAFETERIA PLAN? CAFETERIA PLAN EMPLOYER GUIDE 17

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