Section 125: New Proposed Regulations October 2007

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1 Briefing Section 125: New Proposed Regulations October 2007 Once again, the Internal Revenue Service is poised to revise the regulations for Section 125. The IRS recently issued new proposed regulations that supplant the proposed regulations issued in 1984, 1989, 1997 and 2000 as well as the temporary regulations issued in These regulations are proposed to be effective for plan years beginning on or after January 1, Employers should, however, review their cafeteria plans for compliance now, since the IRS has said that employers can rely on the proposed regulations until final regulations are issued. New Regulation Effective Now Group Term Life Insurance There is one requirement that is effective now, pertaining to group term life insurance. Cafeteria plans can already offer up to a maximum of $50,000 in group term life insurance. Effective now, they can also offer excess coverage. The value of the excess coverage is includible in the employee s income, determined using the rules of section and Table I and reduced by any amount paid by the employee with after-tax dollars. The proposed regulations are extensive and are not all detailed in full in this Briefing. However, most may be broken down into the following categories: written plan requirements, qualified and nonqualified benefits, deferred compensation, elections, Flexible Spending Accounts ( FSAs ), substantiation of expenses and nondiscrimination. Written Plan Requirements While it is not new that Section 125 plans must be in writing, the proposed regulations expand what information is required to be included in the plan document. A written plan must: Describe all benefits and periods of coverage, Set forth the rules for eligibility to participate, Set forth the procedure for making elections, including when elections are made and when they are effective, Describe how employer contributions may be made, State the maximum amount of elective contributions, State the plan year, If a plan includes an FSA, it must include provisions complying with the uniform coverage rule and the use-or-lose rule (formerly the use-it-or-lose-it rule), If a plan offers paid time off ( PTO ), the written plan must include the ordering rule for use of elective and nonelective PTO, and If the plan includes a grace period, the written plan must set forth its provisions Keenan & Associates Lic. #

2 Health, dependent care and adoption assistance FSAs may be written as separate plan documents, or set forth in the cafeteria plan document. If a health FSA permits qualified Health Savings Account ( HSA ) distributions, the written plan must state the rules. The proposed regulations also prohibit retroactive amendment of plans. This provision makes it especially important for employers to anticipate situations and draft plan language with care. If an employer does not comply with the written plan rules, the plan will not be deemed a cafeteria plan. The result will be that the employees cafeteria plan elections will be included in their taxable gross income. Qualified and Nonqualified Benefits A cafeteria plan is a separate written plan maintained by an employer for employees that complies with the requirements of Section 125 of the Internal Revenue Code and applicable regulations. A cafeteria plan permits participants to choose among at least one permitted taxable benefit and at least one qualified nontaxable benefit. Plans that offer choices between all taxable or all nontaxable benefits are not cafeteria plans. The new proposed regulations make some changes to the definition of non-qualified benefits. Scholarships, employer-provided meals and lodging, educational assistance, fringe benefits, group term life insurance on the life of any individual other than an employee, HRAs, and contributions to Archer MSAs are still nonqualified benefits. Under the proposed regulations, long-term care services, and elective deferrals to a 403(b) plan are also nonqualified benefits. These benefits may not be offered through a cafeteria plan, and Plan administrators should examine their cafeteria plans to remove elective deferrals to a 403(b), long-term care or any other impermissible benefits. Permissible taxable benefits are generally thought of as cash and cash equivalents. For purposes of Section 125, cash includes compensation, paid time off, and severance pay. Pension payments are not permitted taxable benefits. Therefore an employer cannot permit its retirees to use salary reduction from pension payments to pay pre-tax for retiree health insurance. The new regulations do, however, allow cafeteria plans to allow a terminating employee to use severance pay to pay for COBRA premiums on a pre-tax basis. Employers that wish to make that option available to terminating employees should consider amending their cafeteria plans. Deferred Compensation Generally, it is impermissible to use a cafeteria plan to provide deferred compensation to employees. The new rules make some changes to what is considered deferred compensation. Under the new rules, a cafeteria plan may allow employees to buy or sell paid time off ( PTO ), provided that the written plan includes the required ordering rule for the use of non-elective and elective PTO. Carryovers or year-end cash-outs of unused elective PTO are not permitted. Furthermore, the new regulations provide that there is no deferred compensation if an accident and health policy has features that apply for more than one year, like credit toward the deductible for unreimbursed expenses incurred in prior periods, reasonable lifetime limits on benefits, premium waiver for periods of disability, coverage for specific illnesses or payment of a fixed daily amount for hospitalizations Keenan & Associates Lic. #

3 Elections The new proposed regulations allow cafeteria plans to provide that new employees can make an election within thirty (30) days of the date of hire. The new regulations also provide that new elections and revocations or changes can be made electronically. FSAs There are three types of FSAs available under the tax code: dependent care assistance, adoption assistance, and medical care reimbursement (commonly referred to as a health FSA). Most of the basic rules for FSAs (the uniform coverage rule for health FSAs, the maximum amount of benefit, and the use-or-lose rule) remain the same as prior proposed regulations, but there have been some changes in the rules regarding FSAs. While the required period of coverage for all FSAs continues to be 12 months, there is an exception for short plan years. In the case of a short plan year, the period of coverage is the entire short plan year. A short plan year of less than 12 consecutive months is permitted for a valid business purpose. (Plan years may not be changed if a principal purpose of the change is to circumvent the rules of Section 125 or the regulations.) Examples of valid business purposes identified in the regulations are (1) an employer with a calendar taxable year which establishes a cafeteria plan mid-year (2) an employer that changes insurance carriers in the middle of a plan year. Also new under the proposed regulations is the provision that the period of coverage and the plan year need not be the same. Moreover, FSAs for different qualified benefits need not have the same coverage period. However, for ease of administration, we recommend that employers have the same period of coverage and plan year. Health FSAs There are several new regulations particular to health FSAs. A cafeteria plan may limit enrollment in a health FSA to those employees who participate in the employer s accident and health plan. A health FSA may also limit payment or reimbursement to only certain medical expenses allowable under IRC 213(d). For instance, a health FSA in a cafeteria plan is permitted to provide in the written plan that the plan reimburses all section 213(d) expenses allowed to be paid or reimbursed under a cafeteria plan except over-the-counter drugs. Employers should assess whether they want to limit the expenses their health FSA will reimburse. Health FSAs may also be HSA-compatible, limited-purpose or post-deductible health FSAs. The prior guidance on these types of FSAs is restated in the proposed regulations, with some clarifications. The proposed regulations clarify: Expenses for preventive care can be paid from a limited-purpose health FSA or post-deductible health FSA even before the deductible is satisfied. Expenses incurred before the High Deductible Health Plan (HDHP) deductible has been satisfied are not eligible under these types of FSAs Keenan & Associates Lic. #

4 A participant in a post-deductible health FSA must provide information from an independent third party that the HDHP deductible has been satisfied. A participant in a limited-purpose health FSA must provide information from an independent third party that the medical expenses are for vision, dental or preventive care. A health FSA that reimburses an employee for durable medical equipment that may be useful beyond the coverage period does not provide deferred compensation, which is prohibited under Section 125. Under the proposed regulations, a cafeteria plan may reimburse employees for orthodontia services before they are rendered, but only to the extent that the employee has actually made advance payment for the services. A cafeteria plan does not have to allow for this advance payment reimbursement. Employers should assess whether they wish to revise their health FSAs regarding advance payment for orthodontia. Dependent Care Assistance Programs ( DCAP ) FSAs Under the new proposed rules, DCAPs can still only reimburse incurred, qualifying dependent care expenses. However, a new optional rule permits an employer to reimburse a terminated employee s qualified dependent care expenses through a dependent care FSA under some circumstances. This DCAP spend-down provision must be written into the plan document. 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, recurring expenses and real-time substantiation. The new proposed regulations also allow for point-of-sale substantiation for approved debit card transactions at merchants whose inventory information approval system (IIAS) complies with the new regulations. Under the proposed regulations, employers whose employees improperly use a debit card may take the following actions, in the order listed below: 1. Deactivate card, 2. Demand repayment from employee, 3. Withhold repayment from wages, 4. Use debt as an offset, and 5. Treat as bad debt. Nondiscrimination The new proposed regulations give additional guidance on the cafeteria plan nondiscrimination rules and define several key terms. They require the employer to perform nondiscrimination testing as of the last day of each plan year. Employers must include any non-includible employees who were employees at any time during the year. The new regulations also include guidance on the safe harbor provision for health benefits and create a new safe harbor for premium-only plans. A premium-only plan is one that offers as its sole benefit an election between cash and payment of the employee share of the employer-provided accident and health insurance premium. This type of plan may gain greater usage in California if Governor Schwarzenegger s health reform plan, which requires all employers to establish Section 125 plans for the payment of premiums, becomes law Keenan & Associates Lic. #

5 Finally, the new proposed regulations enumerate several reasons a plan would fail to satisfy Section 125: Failure to satisfy written plan requirements or operate according to written plan, Offering non-permitted benefits or not offering an election between one permitted taxable or one qualified benefit, Operating to defer compensation, except as permitted, Not following uniform coverage rule, Not following use-or-lose rule, Reimbursing ineligible expenses for an FSA, Failing to substantiate FSA expenses, Not complying with grace period or qualified HSA distribution rules, Letting employees revoke elections or make elections mid-year, with certain exceptions, or Reimbursing expenses incurred before the period of coverage. Employers should regularly audit their plans to ensure that they are in compliance with these new regulations. The penalty for failure to comply is that the IRS will deem all of these benefits as taxable income to your employees Keenan & Associates Lic. #