The IRS has issued a long string of regulations and rulings on “cafeteria plans” over the past 20 years. Even expert tax practitioners have trouble keeping up with all the stops and starts. But a new comprehensive set of proposed regulations look like the real deal. (NPRM REG-142696-05)
Strategy: Amend an existing plan to comply with the new regs. For most companies, the updates will be minor. If you adopt a cafeteria plan for the first time in 2008, use these new regulations as a guideline.
The new proposed regulations are mandatory for plan years beginning after 2008, but the IRS says you can rely on them now. That’s a good indication that they’re here to stay.
Here’s the whole story: Under a cafeteria plan authorized by Section125 of the tax code, you can provide employees with a “menu” of tax-free to choose from in lieu of cash compensation. Benefits that are exempt from tax under a specific code provision can be put up for grabs.
Because your company only pays for the benefits it actually provides, it cuts waste and saves money overall. That makes happy. And employees are happy because they receive the benefits they truly want without paying tax. So everyone wins.
Here’s a capsule summary of the new regs’ main points:
Plan basics: The company must establish a cafeteria plan in a formal written document. Only employees may participate, but former employees may be allowed to participate if they don’t predominate. Sole proprietors, partners, corporate directors and 2%-or-more S corp shareholders aren’t employees for this purpose.
The new proposed regulations also clarify that deferred compensation cannot be included as an option in a cafeteria plan.
Anti-discrimination tests: The company must treat any fringe benefits provided to highly compensated employees and key employees as taxable income if the cafeteria plan is discriminatory. The new regulations require new nondiscrimination testing as to eligibility, contributions and benefits. Previously, there was no real substantive guidance concerning these practices.
Benefit choices: With a cafeteria plan, an employee can choose from a statutory tax-free benefit or a taxable one (usually cash). The new regs definitively state that a Sec. 125 plan is the only mechanism that may be used. This wasn’t entirely clear under previous regulations. Furthermore, a cafeteria plan will be treated as violating Section 125 if it offers a taxable (e.g., a country club membership).
Plan elections: The election to choose a particular benefit must be made by the earlier of the first day of coverage or when benefits are first available. This irrevocable election can’t be revised during the year unless a participant’s status changes (e.g., marriage, divorce or birth of a child). New hires may make an election within 30 days of their hiring date. Note: For the first time, the regulations allow new employees to claim benefits dating back to their hiring date.
Health benefits: Under the new regs, an employer-sponsored health and accident plan may qualify as a tax-free fringe benefit. The cafeteria plan also may be used to pay health insurance premiums. It can provide a 2 1/2-month “grace period”at year-end to cover health care expenses. A grace period also is permitted for dependent care expenses.
Flexible spending arrangements: A flexible spending arrangement (FSA) reimburses employees for certain expenses such as health care costs and dependent care assistance. Under the“uniform coverage rule,” the maximum benefit from a health FSA must be available at all times, regardless of the amount contributed.
Tip: Changes to an existing plan must be made in writing. Consult with a benefits pro concerning your plan.
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