[Federal Register Volume 72, Number 150 (Monday, August 6, 2007)]
[Proposed Rules]
[Pages 43938-43968]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-14827]
[[Page 43937]]
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Part III
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Employee Benefits--Cafeteria Plans; Proposed Rule
Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 /
Proposed Rules
[[Page 43938]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-142695-05]
RIN 1545-BF00
Employee Benefits--Cafeteria Plans
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Withdrawal of prior notices of proposed rulemaking, notice of
proposed rulemaking and notice of public hearing.
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SUMMARY: This document contains new proposed regulations providing
guidance on cafeteria plans. This document also withdraws the notices
of proposed rulemaking relating to cafeteria plans under section 125
that were published on May 7, 1984, December 31, 1984, March 7, 1989,
November 7, 1997 and March 23, 2000. In general, these proposed
regulations would affect employers that sponsor a cafeteria plan,
employees that participate in a cafeteria plan, and third-party
cafeteria plan administrators.
DATES: Written or electronic comments must be received by November 5,
2007. Outlines of topics to be discussed at the hearing scheduled for
November 15, 2007, at 10 a.m., must be received by October 25, 2007.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-142695-05), room
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
142695-05), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue, NW., Washington, DC or sent electronically via the Federal
eRulemaking Portal at http://www.regulations.gov (IRS REG-142695-05).
The public hearing will be held at the IRS Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW., Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Mireille T. Khoury at (202) 622-6080; concerning submissions of
comments, the hearing, and/or to be placed on the building access list
to attend the hearing, Oluwafunmilayo Taylor of the Publications and
Regulations Branch at (202) 622-7180 (not toll-free numbers).
SUPPLEMENTARY INFORMATION
Paperwork Reduction Act
The collections of information contained in this notice of proposed
rulemaking have been submitted to the Office of Management and Budget
for review in accordance with the Paperwork Reduction Act of 1995 (44
U.S.C. 3507(d)). Comments on the collections of information should be
sent to the Office of Management and Budget, Attn: Desk Officer for the
Department of Treasury, Office of Information and Regulatory Affairs,
Washington, DC 20503, with copies to the Internal Revenue Service,
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC
20224. Comments on the collections of information should be received by
October 5, 2007. Comments are specifically requested concerning:
Whether the proposed collections of information are necessary for
the proper performance of the functions of the Internal Revenue
Service, including whether the information will have practical utility;
The accuracy of the estimated burden associated with the proposed
collection of information;
How the quality, utility, and clarity of the information to be
collected may be enhanced;
How the burden of complying with the proposed collections of
information may be minimized, including through the application of
automatic collection techniques or other forms of information
technology; and
Estimates of the capital or start-up costs and costs of operation,
maintenance, and purchase of service to provide information.
The collection of information in this proposed regulation is in
Sec. 1.125-2 (cafeteria plan elections); Sec. 1.125-6(b)-(g)
(substantiation of expenses), and Sec. 1.125-7 (cafeteria plan
nondiscrimination rules). This information is required to file
employment tax returns and Forms W-2. The collection of information is
voluntary to obtain a benefit. The likely respondents are Federal,
state or local governments, business or other for-profit institutions,
nonprofit institutions, and small businesses or organizations.
Estimated total annual reporting burden: 34,000,000 hours.
Estimated average annual burden per respondent: 5 hours.
Estimated annual frequency of responses: once.
An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
Books or records relating to a collection of information must be
retained as long as their contents may become material in the
administration of any internal revenue law. Generally, tax returns and
tax return information are confidential, as required by 26 U.S.C. 6103.
Background
This document contains proposed Income Tax Regulations (26 CFR Part
1) under section 125 of the Internal Revenue Code (Code). On May 7,
1984, December 31, 1984, March 7, 1989, November 7, 1997, and March 23,
2000, the IRS and Treasury Department published proposed amendments to
26 CFR Part 1 under section 125 in the Federal Register (49 FR 19321,
49 FR 50733, 54 FR 9460, 62 FR 60196 and 65 FR 15587). These 1984,
1989, 1997 and 2000 proposed regulations are hereby withdrawn. Also,
the temporary regulations under section 125 that were published on
February 4, 1986 in the Federal Register (51 FR 4318) are being
withdrawn in a separate document. The new proposed regulations that are
published in this document replace those proposed regulations.
Explanation of Provisions
Overview
The new proposed regulations are organized as follows: general
rules on qualified and nonqualified benefits in cafeteria plans (new
proposed Sec. 1.125-1), general rules on elections (new proposed Sec.
1.125-2), general rules on flexible spending arrangements (new proposed
Sec. 1.125-5), general rules on substantiation of expenses for
qualified benefits (new proposed Sec. 1.125-6) and nondiscrimination
rules (new proposed Sec. 1.125-7). The new proposed regulations, new
Proposed Sec. Sec. 1.125-1, 1.125-2, 1.125-5, 1.125-6 and Sec. 1.125-
7, consolidate and restate Proposed Sec. 1.125-1 (1984, 1997, 2000),
Sec. 1.125-2 (1989, 1997, 2000) and Sec. 1.125-2T (1986). Unless
otherwise indicated, references to ``new proposed regulations'' or
``these proposed regulations'' mean the proposed section 125
regulations being published in this document.
The new proposed regulations reflect changes in tax law since the
prior regulations were proposed, including: the change in the
definition of dependent (section 152) and the addition of the following
as qualified benefits: adoption assistance (section 137), additional
deferred compensation benefits described in section 125(d)(1)(B), (C)
and (D), Health Savings
[[Page 43939]]
Accounts (HSAs) (sections 223, 125(d)(2)(D) and 4980G), and qualified
HSA distributions from health FSAs (section 106(e)). Other changes
include the prohibition against long-term care insurance and long-term
care services (section 125(f)) and the addition of the key employee
concentration test in section 125(b)(2).
The prior proposed regulations, Sec. Sec. 1.125-1 and 1.125-2,
provide the basic framework and requirements for cafeteria plans and
elections under cafeteria plans. The prior proposed regulations also
outlined the most significant rules for benefits under a health
flexible spending arrangement (health FSA) offered by a cafeteria
plan--the requirement that the maximum reimbursement be available at
all times during the coverage period (the uniform coverage rule), the
requirement of a 12-month period of coverage, the requirement that the
health FSA only reimburse medical expenses, the requirement that all
medical expenses be substantiated by a third party before
reimbursement, the requirement that expenses be incurred during the
period of coverage, and the prohibition against deferral of
compensation (including the use-or-lose rule). The prior proposed
regulations also provided guidelines for dependent care FSAs, and the
application of section 125 to paid vacation days offered under a
cafeteria plan. These remain substantially unchanged in the new
proposed regulations, with certain clarifications. Finally, the prior
proposed regulations included a number of Q & As addressing
transitional issues relating to the enactment of section 125, as well
as the application of the now-repealed section 89 (special
nondiscrimination rules with respect to certain employee benefit
plans). These provisions are omitted from the new proposed regulations.
I. New Proposed Sec. 1.125-1--Qualified and Nonqualified Benefits in
Cafeteria Plans Section 125 Exclusive Noninclusion Rule
Section 125 provides that, except in the case of certain
discriminatory benefits, no amount shall be included in the gross
income of a participant in a cafeteria plan (as defined in section
125(d)) solely because, under the plan, the participant may choose
among the benefits of the plan. The new proposed regulations clarify
and amplify the general rule in the prior proposed regulations that
section 125 is the exclusive means by which an employer can offer
employees a choice between taxable and nontaxable benefits without the
choice itself resulting in inclusion in gross income by the employees.
When employees may elect between taxable and nontaxable benefits, this
election results in gross income to employees, unless a specific
Internal Revenue Code (Code) section (such as section 125) intervenes
to prevent gross income inclusion. Thus, except for an election made
through a cafeteria plan that satisfies section 125 or another specific
Code section (such as section 132(f)(4)), any opportunity to elect
among taxable and nontaxable benefits results in inclusion of the
taxable benefit regardless of what benefit is elected and when the
election is made. This interpretation of section 125 is consistent with
the legislative history of section 125. The legislative history begins
with the interim ERISA rules for cafeteria plans:
Under * * * ERISA, an employer contribution made before January
1, 1977, to a cafeteria plan in existence on June 27, 1974, is
required to be included in an employees' gross income only to the
extent that the employee actually elects taxable benefits. In the
case of a plan not in existence on June 27, 1974, the employer
contribution is required to be included in an employee's gross
income to the extent the employee could have elected taxable
benefits. S. Rep. No. 1263, 95th Cong., 2d Sess. 74 (1978),
reprinted in 1978 U.S.C.C.A.N. 6837; H. R. Rep. No. 1445, 95th
Cong., 2d Sess. 63 (1978); H.R. Conf. Rep. No. 1800, 95th Cong., 2d
Sess. 206 (1978).
The legislative history also provides:
[G]enerally, employer contributions under a written cafeteria
plan which permits employees to elect between taxable and nontaxable
benefits are excluded from the gross income of an employee to the
extent that nontaxable benefits are elected. S. Rep. No. 1263, 95th
Cong., 2d Sess. 75 (1978), reprinted in 1978 U.S.C.C.A.N. 6838; H.
R. Rep. No. 1445, 95th Cong., 2d Sess. 63 (1978). See also H.R.
Conf. Rep. No. 1800, 95th Cong., 2d Sess. 206 (1978).
The legislative history to the 1984 amendments to section 125
continues:
The cafeteria plan rules of the Code provide that a participant
in a nondiscriminatory cafeteria plan will not be treated as having
received a taxable benefit offered under the plan solely because the
participant has the opportunity, before the benefit becomes
available, to choose among the taxable and nontaxable benefits under
the plan.
H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 1173 (1984),
reprinted in 1984 U.S.C.C.A.N. 1861. See also H.R. Conf. Rep. No.
736, 104th Cong., 2d Sess. 295, reprinted in 1996 U.S.C.C.A.N. 2108.
The new proposed regulations provide that unless a plan satisfies
the requirements of section 125 and the regulations, the plan is not a
cafeteria plan. Reasons that a plan would fail to satisfy the section
125 requirements include: Offering nonqualified benefits; not offering
an election between at least one permitted taxable benefit and at least
one qualified benefit; deferring compensation; failing to comply with
the uniform coverage rule or use-or-lose rule; allowing employees to
revoke elections or make new elections during a plan year, except as
provided in Sec. 1.125-4; failing to comply with substantiation
requirements; paying or reimbursing expenses incurred for qualified
benefits before the effective date of the cafeteria plan or before a
period of coverage; allocating experience gains (forfeitures) other
than as expressly allowed in the new proposed regulations; and failing
to comply with grace period rules.
Definition of a Cafeteria Plan
The new proposed regulations provide that a cafeteria plan is a
separate written plan that complies with the requirements of section
125 and the regulations, that is maintained by an employer for
employees and that is operated in compliance with the requirements of
section 125 and the regulations. Participants in a cafeteria plan must
be permitted to choose among at least one permitted taxable benefit
(for example, cash, including salary reduction) and at least one
qualified benefit. A plan offering only elections among nontaxable
benefits is not a cafeteria plan. Also, a plan offering only elections
among taxable benefits is not a cafeteria plan. See Rev. Rul. 2002-27,
Situation 2 (2002-1 CB 925), see Sec. 601.601(d)(2)(ii)(b). Finally, a
cafeteria plan must not provide for deferral of compensation, except as
specifically permitted in section 125(d)(2)(B), (C), or (D).
Written Plan
Section 125(d)(1) requires that a cafeteria plan be in writing. The
cafeteria plan must be operated in accordance with the written plan
terms. The new proposed regulations require that the written plan
specifically describe all benefits, set forth the rules for eligibility
to participate and the procedure for making elections, provide that all
elections are irrevocable (except to the extent that the plan includes
the optional change in status rules in Sec. 1.125-4), and state how
employer contributions may be made under the plan (for example, salary
reduction or nonelective employer contributions), the maximum amount of
elective contributions, and the plan year. If the plan includes a
flexible spending arrangement (FSA), the written plan must include
provisions complying
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with the uniform coverage rule and the use-or-lose rule. Because
section 125(d)(1)(A) states that a cafeteria plan is a written plan
under which ``all participants are employees,'' the new proposed
regulations require that the written cafeteria plan specify that only
employees may participate in the cafeteria plan. The new proposed
regulations also require that all provisions of the written plan apply
uniformly to all participants.
Individuals Who May Participate in a Cafeteria Plan
All participants in a cafeteria plan must be employees. See section
125(d)(1)(A). These proposed regulations provide that employees include
common law employees, leased employees described in section 414(n), and
full-time life insurance salesmen (as defined in section 7701(a)(20)).
These proposed regulations further provide that former employees
(including laid-off employees and retired employees) may participate in
a plan, but a plan may not be maintained predominantly for former
employees. See Rev. Rul. 82-196 (1982-2 CB 53); Rev. Rul. 85-121 (1985-
2 CB 57), see Sec. 601.601(d)(2)(ii)(b). All employees who are treated
as employed by a single employer under section 414(b), (c) or (m) are
treated as employed by a single employer for purposes of section 125.
See section 125(g)(4). A participant's spouse or dependents may receive
benefits through a cafeteria plan although they cannot participate in
the cafeteria plan.
Self-employed individuals are not treated as employees for purposes
of section 125. Accordingly, the new proposed regulations make clear
that sole proprietors, partners, and directors of corporations are not
employees and may not participate in a cafeteria plan. In addition, the
new proposed regulations clarify that 2-percent shareholders of an S
corporation are not employees for purposes of section 125. The new
proposed regulations provide rules for dual status individuals and
individuals moving between employee and non-employee status. A self-
employed individual may, however, sponsor a cafeteria plan for his or
her employees.
Election Between Taxable and Nontaxable Benefits
The new proposed regulations require that a cafeteria plan offer
employees an election among only permitted taxable benefits (including
cash) and qualified nontaxable benefits. See section 125(d)(1)(B). For
purposes of section 125, cash means cash from current compensation
(including salary reduction), payment for annual leave, sick leave, or
other paid time off, severance pay, property, and certain after-tax
employee contributions. Distributions from qualified retirement plans
are not cash or taxable benefits for purposes of section 125. See Rev.
Rul. 2003-62 (2003-1 CB 1034) (distributions to former employees from a
qualified employees' trust, applied to pay health insurance premiums,
are includible in former employees' gross income under section 402),
see Sec. 601.601(d)(2)(ii)(b).
Qualified Benefits
In general, in order for a benefit to be a qualified benefit for
purposes of section 125, the benefit must be excludible from employees'
gross income under a specific provision of the Code and must not defer
compensation, except as specifically allowed in section 125(d)(2)(B),
(C) or (D). Examples of qualified benefits include the following:
group-term life insurance on the life of an employee (section 79);
employer-provided accident and health plans, including health flexible
spending arrangements, and accidental death and dismemberment policies
(sections 106 and 105(b)); a dependent care assistance program (section
129); an adoption assistance program (section 137); contributions to a
section 401(k) plan; contributions to certain plans maintained by
educational organizations, and contributions to HSAs. Section 125(f),
(d)(2)(B), (C), (D). See Notice 97-9 (1997-2 CB 35) (adoption
assistance), see Sec. 601.601(d)(2)(ii)(b); Notice 2004-2, Q & A-33
(2004-1 CB 269) (HSAs), see Sec. 601.601(d)(2)(ii)(b). A cafeteria
plan may also offer long-term and short-term disability coverage as a
qualified benefit (see section 106). However, see paragraph (q) in
Sec. 1.125-1 for nonqualified benefits.
Group-Term Life Insurance
An employer may provide group-term life insurance through a
combination of methods. Generally, under section 79(a), the cost of
$50,000 or less of group-term life insurance on the life of an employee
provided under a policy (or policies) carried directly or indirectly by
an employer is excludible from the employee's gross income. (Special
rules apply to key employees if the group-term life insurance plan does
not satisfy the nondiscrimination rules in section 79(d)). However, if
the group-term life insurance provided to an employee by an employer or
employers exceeds $50,000 (taking into account all coverage provided
both through a cafeteria plan and outside a cafeteria plan), the cost
of coverage exceeding coverage of $50,000 is includible in the
employee's gross income. For this purpose, the cost of group-term life
insurance is shown in Sec. 1.79-3(d)(2), Table I (Table I). The Table
I cost of the excess group-term life insurance (minus all after-tax
contributions by the employee for group-term life insurance coverage)
is includible in each covered employee's gross income. The new proposed
regulations provide that the cost of group-term life insurance on the
life of an employee, that either is less than or equal to the amount
excludible from gross income under section 79(a) or provides coverage
in excess of that amount, but not combined with any permanent benefit,
is a qualified benefit that may be offered in a cafeteria plan. The new
proposed regulations also provide that the entire amount of salary
reduction and employer flex-credits for group-term life insurance
coverage on the life of an employee is excludible from an employee's
gross income.
The rule in the new proposed regulations differs from Notice 89-110
(1989-2 CB 447), see Sec. 601.601(d)(2)(ii)(b). Notice 89-110 provides
that an employee includes in gross income the greater of the Table I
cost of group-term life insurance coverage exceeding $50,000 or the
employee's salary reduction and employer flex-credits for excess group-
term life insurance coverage. The new proposed regulations provide
instead that the employee includes in gross income the Table I cost of
the excess coverage (minus all after-tax contributions by the employee
for group-term life insurance coverage) and that the entire amount of
salary reduction and employer flex-credits for group-term life
insurance coverage on the life of the employee is excludible from the
employee's gross income. As noted in this preamble, taxpayers may rely
on the new proposed regulations for guidance pending the issuance of
final regulations.
Employer-Provided Accident and Health Plan
Coverage under an employer-provided accident and health plan that
satisfies the requirements of section 105(b) may be provided as a
qualified benefit through a cafeteria plan and is excludible from
employees' gross income. Section 106; Sec. 1.106-1. The
nondiscrimination rules under section 105(h) apply to self-insured
medical reimbursement arrangements (including health FSAs).
The new proposed regulations specifically permit a cafeteria plan
(but
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not a health FSA) to pay or reimburse substantiated individual accident
and health insurance premiums. See Rev. Rul. 61-146 (1961-2 CB 25), see
Sec. 601.601(d)(2)(ii)(b). In addition, a cafeteria plan may provide
for payment of COBRA premiums for an employee.
For employer-provided accident and health plans and medical
reimbursement plans, the definition of dependents is the definition in
section 105(b) as amended by the Working Families Tax Relief Act of
2004 (WFTRA), Public Law 108-311, section 207(9) (118 Stat. 1166) (that
is, a dependent as defined in section 152, determined without regard to
section 152(b)(1), (b)(2), or (d)(1)(B)). See Notice 2004-79 (2004-2 CB
898), see Sec. 601.601(d)(2)(ii)(b). For purposes of the exclusion
from employees' gross income for accident and health plans and for
medical reimbursement under sections 105(b) and 106, the spouse or
dependent of a former employee (including a retired employee or a laid-
off employee) or of a deceased employee is treated as a spouse or
dependent. See Rev. Rul. 82-196 (1982-2 CB 53); Rev. Rul. 85-121 (1985-
2 CB 57), see Sec. 601.601(d)(2)(ii)(b).
Dependent Care Assistance Programs and Adoption Assistance Programs
If the requirements of section 129 are satisfied, up to $5,000 of
employer-provided assistance for amounts paid or incurred by employees
for dependent care is excludible from employees' gross income. The new
proposed regulations outline the general requirements for providing
dependent care assistance programs and adoption assistance programs
under section 137 through a cafeteria plan. See Notice 97-9, section II
(1997-2 CB 35), see Sec. 601.601(d)(2)(ii)(b).
Cafeteria Plan Year
The new proposed regulations require that a cafeteria plan year
must be 12 consecutive months and must be set out in the written
cafeteria plan. A short plan year (or a change in plan year resulting
in a short plan year) is permitted only for a valid business purpose. A
change in plan year resulting in a short plan year, for other than a
valid business purpose, is disregarded. If a principal purpose of a
change in plan year is to circumvent the rules of section 125, the
change in plan year is ineffective.
No Deferral of Compensation
Qualified benefits must be current benefits. In general, a
cafeteria plan may not offer benefits that defer compensation or
operate to defer compensation. Section 125(d)(2)(A). In general,
benefits may not be carried over to a later plan year or used in one
plan year to purchase benefits to be provided in a later plan year. For
example, life insurance with a cash value build-up or group-term life
insurance with a permanent benefit (within the meaning of Sec. 1.79-0)
defers the receipt of compensation and thus is not a qualified benefit.
The new proposed regulations clarify whether certain benefits and
plan administration practices defer compensation. For example, the
regulations permit an accident and health insurance policy to provide
certain benefit features that apply for more than one plan year, such
as reasonable lifetime limits on benefits, level premiums, premium
waiver during disability, guaranteed renewability of coverage, coverage
for specified accidental injury or specific diseases, and the payment
of a fixed amount per day for hospitalization. But these insurance
policies must not provide an investment fund or cash value to pay
premiums, and no part of the premium may be held in a separate account
for any beneficiary. The new proposed regulations also provide that the
following benefits and practices do not defer compensation: a long-term
disability policy paying benefits over more than one plan year;
reasonable premium rebates or policy dividends; certain two-year lock-
in vision and dental policies; certain advance payments for
orthodontia; salary reduction contributions in the last month of a plan
year used to pay accident and health insurance premiums for the first
month of the following plan year; reimbursement of section 213(d)
expenses for durable medical equipment; and allocation of experience
gains (forfeitures) among participants.
Paid Time Off
Under the prior proposed regulations, permitted taxable benefits
included various forms of paid leave. Since the prior proposed
regulations were issued, many employers have recharacterized and
combined vacation days, sick leave and personal days into a single
category of ``paid time off.'' The new proposed regulations use the
term ``paid time off'' to refer to vacation days and other types of
paid leave. The new proposed regulations contain the same ordering rule
for elective and nonelective paid time off as set forth in Prop. Sec.
1.125-1, Q & A-7 (1984). A plan offering an election solely between
paid time off and taxable benefits is not a cafeteria plan.
Grace Period
The new proposed regulations allow a written cafeteria plan to
provide an optional grace period immediately following the end of each
plan year, extending the period for incurring expenses for qualified
benefits. A grace period may apply to one or more qualified benefits
(for example, health FSA or dependent care assistance program) but in
no event does it apply to paid time off or contributions to section
401(k) plans. Unused benefits or contributions for one qualified
benefit may only be used to reimburse expenses incurred during the
grace period for that same qualified benefit. The amount of unused
benefits and contributions available during the grace period may be
limited by the employer. A grace period may extend to the fifteenth day
of the third month after the end of the plan year (but may be for a
shorter period). Benefits or contributions not used as of the end of
the grace period are forfeited under the use-or-lose rule. The grace
period applies to all employees who are participants (including through
COBRA), as of the last day of the plan year. Grace period rules must
apply uniformly to all participants. The grace period rules in these
proposed regulations are based on Notice 2005-42 (2005-1 CB 1204),
modified in Notice 2007-22 (2007-10 IRB 670), see Sec.
601.601(d)(2)(ii)(b), amplified in Notice 2005-86 (2005-2 CB 1075),
amplified in Notice 2007-22 (2007-10 IRB 670), see Sec.
601.601(d)(2)(ii)(b). For eligibility to contribute to a Health Savings
Account (HSA) during a grace period, see Notice 2005-86 (2005-2 CB
1075), see Sec. 601.601(d)(2)(ii)(b). For Form W-2 reporting for
unused dependent care assistance used for expenses incurred during a
grace period, see Notice 2005-61 (2005-2 CB 607), see Sec.
601.601(d)(2)(ii)(b).
Contributions to Section 401(k) Plans Through a Cafeteria Plan
A cafeteria plan may include contributions to a section 401(k)
plan. Section 125(d)(2)(B). The new proposed regulations clarify the
interactions between section 125 and section 401(k). Contributions to a
section 401(k) plan expressed as a percentage of compensation are
permitted. Pursuant to Sec. 1.401(k)-1(a)(3)(ii), elective
contributions to a section 401(k) plan may be made through automatic
enrollment (that is, when the employee does not affirmatively elect
cash, the employee's compensation is reduced by a fixed percentage,
which is contributed to a section 401(k) plan).
[[Page 43942]]
Nonqualified Benefits
A cafeteria plan must not offer any of the following benefits:
scholarships (section 117); employer-provided meals and lodging
(section 119); educational assistance (section 127); fringe benefits
(section 132); long-term care insurance. See section 125(f). Long-term
care services are nonqualified benefits, H.R. Conf. Rep. No. 736, 104th
Cong., 2d Sess. 29, reprinted in 1996 U.S.C.C.A.N. 2109. (An HSA funded
through a cafeteria plan may, however, be used to pay premiums for
long-term care insurance or for long-term care services.) The new
proposed regulations clarify that contributions to Archer Medical
Savings Accounts (sections 220, 106(b)), group term life insurance for
an employee's spouse, child or dependent, and elective deferrals to
section 403(b) plans are also nonqualified benefits. A plan offering
any nonqualified benefit is not a cafeteria plan. A cafeteria plan may
not offer a health FSA that provides for the carryover of unused
benefits. See Notice 2002-45, Part I (2002-2 CB 93); Rev. Rul. 2002-41
(2002-2 CB 75), see Sec. 601.601(d)(2)(ii)(b).
After-Tax Employee Contributions
The new proposed regulations allow a cafeteria plan to offer after-
tax employee contributions for qualified benefits or paid time off. A
cafeteria plan may only offer the taxable benefits specifically
permitted in the new proposed regulations. Nonqualified benefits may
not be offered through a cafeteria plan, even if paid with after-tax
employee contributions.
Employer Contributions Through Salary Reduction
Employees electing a qualified benefit through salary reduction are
electing to forego salary and instead to receive a benefit which is
excludible from gross income because it is provided by employer
contributions. Section 125 provides that the employee is treated as
receiving the qualified benefit from the employer in lieu of the
taxable benefit. A cafeteria plan may also 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.
II. New Prop. Sec. 1.125-2--Elections in Cafeteria Plans
Making, Revoking and Changing Elections
Generally, a cafeteria plan must require employees to elect
annually between taxable benefits and qualified benefits. Elections
must be made before the earlier of the first day of the period of
coverage or when benefits are first currently available. The
determination of whether a taxable benefit is currently available does
not depend on whether it has been constructively received by the
employee for purposes of section 451. Annual elections generally must
be irrevocable and may not be changed during the plan year. However,
Sec. 1.125-4 permits a cafeteria plan to provide for changes in
elections based on certain changes in status. An employer that wishes
to permit such changes in elections must incorporate the rules in Sec.
1.125-4 in its written cafeteria plan. These proposed regulations omit
the rule in Q & A-6(b) in Prop. Sec. 1.125-2 (1989) (cessation of
required contributions), because the change in status rules in Sec.
1.125-4 superseded this provision of the 1989 proposed regulations.
If HSA contributions are made through salary reduction under a
cafeteria plan, employees may prospectively elect, revoke or change
salary reduction elections for HSA contributions at any time during the
plan year with respect to salary that has not become currently
available at the time of the election.
A cafeteria plan is permitted to include an automatic election for
new employees or current employees. Rev. Rul. 2002-27 (2002-1 CB 925),
see Sec. 601.601(d)(2)(ii)(b). A new rule also permits a cafeteria
plan to provide an optional election for new employees between cash and
qualified benefits. New employees avoid gross income inclusion if they
make an election within 30 days after the date of hire even if benefits
provided pursuant to the election relate back to the date of hire.
However, salary reduction amounts used to pay for such an election must
be from compensation not yet currently available on the date of the
election. Also, this special election rule for new employees does not
apply to any employee who terminates employment and is rehired within
30 days after terminating employment (or who returns to employment
following an unpaid leave of absence of less than 30 days).
New elections and revocations or changes in elections can be made
electronically. The safe harbor for electronic elections in Sec.
1.401(a)-21 is available. Only an employee can make an election or
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.
III. New Prop. Sec. 1.125-5--Flexible Spending Arrangements
Overview
In general, a flexible spending arrangement (FSA) is a benefit
designed to reimburse employees for expenses incurred for certain
qualified benefits, up to a maximum amount not substantially in excess
of the salary reduction and employer flex-credits allocated for the
benefit. The maximum amount of reimbursement reasonably available must
be less than five times the value of the coverage. Employer flex-
credits are non-elective employer contributions that an employer makes
available for every employee eligible to participate in the cafeteria
plan, to be used at the employee's election only for one or more
qualified benefits (but not as cash or other taxable benefits). The
three types of FSAs are dependent care assistance, adoption assistance
and medical care reimbursements (health FSA).
Uniform Coverage Rule
The new proposed regulations retain the rule that the maximum
amount of reimbursement from a health FSA must be available at all
times during the period of coverage (properly reduced as of any
particular time for prior reimbursements). The uniform coverage rule
does not apply to FSAs for dependent care assistance or adoption
assistance.
Use-or-Lose Rule
An FSA must satisfy all the requirements of section 125, including
the prohibition against deferring compensation. In general, as
discussed under ``No deferral of compensation'', in order to satisfy
this requirement of section 125, all benefits and contributions must be
used by the end of the plan year (or grace period, if applicable), or
are forfeited. The new proposed regulations continue the use-or-lose
rule.
Period of Coverage
The required period of coverage for all FSAs continues to be twelve
months, with an exception for short plan years that satisfy the
conditions in the new proposed regulations. The period of coverage and
the plan year need not be the same. The beginning and end of a period
of coverage is clarified. The new proposed regulations also clarify
that FSAs for different qualified benefits need not have the same
coverage period. See also ``Grace period'', discussed in this preamble.
The new proposed
[[Page 43943]]
regulations also continue to provide that expenses are incurred when
services are provided. Expenses incurred before or after the period of
coverage may not be reimbursed.
Health FSA
A health FSA may only reimburse certain substantiated section
213(d) medical care expenses incurred by the employee, or by the
employee's spouse or dependents. A health FSA may be limited to a
subset of permitted section 213(d) medical expenses (for example, a
health FSA is permitted to exclude reimbursement of over-the-counter
drugs described in Rev. Rul. 2003-102 (2003-2 CB 559), see Sec.
601.601(d)(2)(ii)(b)). Similarly, a health FSA may be an HSA-compatible
limited-purpose health FSA or post-deductible health FSA. Rev. Rul.
2004-45 (2004-1 CB 971), see Sec. 601.601(d)(2)(ii)(b), amplified,
Notice 2005-86 (2005-2 CB 1075). A health FSA may not reimburse
premiums for accident and health insurance or long-term care insurance.
See section 125(f).
A health FSA must satisfy all requirements of section 105(b),
Sec. Sec. 1.105-1 and 1.105-2. The section 105(h) nondiscrimination
rules apply to health FSAs. All medical expenses must be substantiated
before expenses are reimbursed. See Incurring and reimbursing expenses
for qualified benefits, discussed in this preamble. The new proposed
regulations also clarify when medical expenses are incurred.\1\ A
cafeteria plan may limit enrollment in a health FSA to those employees
who participate in the employer's accident and health plan.
---------------------------------------------------------------------------
\1\ See Rev. Rul. 2005-55 (2005-2 CB 284) and Rev. Rul. 2005-24
(2005-1 CB 892), see Sec. 601.601(d)(2)(ii)(b) (section 105(b)
exclusion only applicable to reimbursements for medical expenses
incurred by employee, or by the employee's spouse or dependents);
Rev. Rul. 2002-3 (2002-1 CB 316) (purported reimbursements to
employees of health insurance premiums not paid by employees and
therefore impermissible); Rev. Rul. 2002-80 (2002-2 CB 925), see
Sec. 601.601(d)(2)(ii)(b) (so-called advance reimbursements and
purported loans are impermissible); Rev. Rul. 2003-43 (2003-1 CB
935), see Sec. 601.601(d)(2)(ii)(b); Notice 2006-69 (2006-31 IRB
107) (substantiation requirements for debit cards), amplified in
Notice 2007-2 (2007-2 IRB 254), see Sec. 601.601(d)(2)(ii)(b).
---------------------------------------------------------------------------
Qualified HSA Distributions
Section 106(e), enacted in section 302 of the Health Opportunity
Patient Empowerment Act of 2006, Public Law 109-432 (120 Stat. 2922
(2006)) allows ``qualified HSA distributions'' from health FSAs to
HSAs. Section 106(e) applies to distributions between December 20, 2006
and December 31, 2011. The proposed regulations incorporate the rules
on qualified HSA distributions set forth in Notice 2007-22 (2007-10 IRB
670). See Sec. 601.601(d)(2)(ii)(b).
Dependent Care Assistance After Termination
A new optional rule permits an employer to reimburse a terminated
employee's qualified dependent care expenses incurred after termination
through a dependent care FSA, if all section 129 requirements are
otherwise satisfied.
Experience Gains
If an employee fails to use all contributions and benefits for a
plan year before the end of the plan year (and the grace period, if
applicable), those unused contributions and benefits are forfeited
under the use-or-lose rule. Unused amounts are also known as experience
gains. The new proposed regulations retain the forfeiture allocation
rules in the 1989 proposed regulations, and clarify that the employer
sponsoring the cafeteria plan may retain forfeitures, use forfeitures
to defray expenses of administering the plan or allocate forfeitures
among employees contributing through salary reduction on a reasonable
and uniform basis.
FSA Administrative Rules
Salary reduction contributions may be made at whatever interval the
employer selects, including ratably over the plan year based on the
employer's payroll periods or in equal installments at other regular
intervals (for example, quarterly installments). These rules must apply
uniformly to all participants.
IV. New Prop. Sec. 1.125-6--Substantiation of Expenses for All
Cafeteria Plans
Incurring and Reimbursing Expenses for Qualified Benefits
The new proposed regulations provide that only expenses for
qualified benefits incurred after the later of the effective date or
the adoption date of the cafeteria plan are permitted to be reimbursed
under the cafeteria plan. Similarly, if a plan amendment adds a new
qualified benefit, only expenses incurred after the later of the
effective date or the adoption date are eligible for reimbursement.\2\
This rule applies to all qualified benefits. Similarly, a cafeteria
plan may pay or reimburse only expenses for qualified benefits incurred
during a participant's period of coverage.
---------------------------------------------------------------------------
\2\ See American Family Mut. Ins. Co. v. United States, 815 F.
Supp. 1206 (W.D. Wis. 1992); Wollenberg v. United States, 75 F.
Supp.2d 1032 (D. Neb. 1999); Rev. Rul. 2002-58 (2002-2 CB 541), see
Sec. 601.601(d)(2)(ii)(b); Notice 97-9, section II (adoption
assistance).
---------------------------------------------------------------------------
Substantiation and Reimbursement of Expenses for Qualified Benefits
The new proposed regulations provide, after an employee incurs an
expense for a qualified benefit during the coverage period, the expense
must first be substantiated before the expense may be paid or
reimbursed. All expenses must be substantiated (substantiating only a
limited number of total claims, or not substantiating claims below a
certain dollar amount does not satisfy the requirements in the new
proposed regulations). See Sec. 1.105-2; Rul. 2003-80; Rev. Rul. 2003-
43 (2002-1 CB 935), see Sec. 601.601(d)(2)(ii)(b); Notice 2006-69
(2006-31 IRB 107), Notice 2007-2 (2007-2 IRB 254). FSAs for dependent
care assistance and adoption assistance must follow the substantiation
procedures applicable to health FSAs.
Debit Cards
The new proposed regulations incorporate previously issued guidance
on substantiating, paying and reimbursing expenses for section 213(d)
medical care incurred at a medical care provider when payment is made
with a debit card. Rev. Rul. 2003-43 (2003-1 CB 935), amplified, Notice
2006-69 (2006-31 IRB 107), Notice 2007-2 (2007-2 IRB 254); Rev. Proc.
98-25 (1998-1 CB 689), see Sec. 601.601(d)(2)(ii)(b). Among the
permissible substantiation methods are copayment matches, recurring
expenses, and real-time substantiation. The new proposed regulations
also allow point-of-sale substantiation through matching inventory
information with a list of section 213(d) medical expenses. The
employer is responsible for ensuring that the inventory information
approval system complies with the new regulations and with the
recordkeeping requirements in section 6001. Rev. Rul. 2003-43 (2003-1
CB 935), amplified, Notice 2006-69 (2006-31 IRB 107), Notice 2007-2
(2007-2 IRB 254); Rev. Proc. 98-25 (1998-1 CB 689), see Sec.
601.601(d)(2)(ii)(b). The new proposed regulations also provide rules
under which an FSA may pay or reimburse dependent care expenses using
debit cards.
Pursuant to prior guidance (in Notice 2006-69 (2006-31 IRB 107),
amplified, Notice 2007-2 (2007-2 IRB 254)), for plan years beginning
after December 31, 2006, the recordkeeping requirements described in
paragraph (f) in Sec. 1.125-6 apply (that is, responsibility of
employers relying on the inventory information approval system for
health
[[Page 43944]]
FSA debit cards to ensure that the system complies with the new
proposed recordkeeping requirements, including Rev. Proc. 98-25 (1998-1
CB 689), Notice 2006-69 (2006-31 IRB 107), amplified, Notice 2007-2
(2007-2 IRB 254). For health FSA debit card transactions occurring on
or before December 31, 2007, all supermarkets, grocery stores, discount
stores and wholesale clubs that do not have a medical care merchant
category code (as described in Rev. Rul. 2003-43 (2003-2 CB 935) are
nevertheless deemed to be an ``other medical provider'' as described in
Rev. Rul. 2003-43. (For a list of merchant category codes, see Rev.
Proc. 2004-43 (2004-2 CB 124).) During this time period, mail-order
vendors and web-based vendors that sell prescription drugs are also
deemed to be an ``other medical provider'' as described in Rev. Rul.
2003-43. After December 31, 2008, health FSA debit cards may not be
used at stores with the Drug Stores and Pharmacies merchant category
code unless (1) the store participates in the inventory information
approval system described in Notice 2006-69, or (2) on a store location
by store location basis, 90 percent of the store's gross receipts
during the prior taxable year consisted of items which qualify as
expenses for medical care under section 213(d) (including
nonprescription medications described in Rev. Rul. 2003-102 (2003-2 CB
559)). Notice 2006-69 (2006-31 IRB 107), amplified, Notice 2007-2
(2007-2 IRB 254).
V. New Prop. Sec. 1.125-7--Nondiscrimination Rules
Discriminatory benefits provided to highly compensated participants
and individuals and key employees are included in these employees'
gross income. See section 125(b), (c). The new proposed regulations
reflect changes in tax law since Prop. Sec. 1.125-1, Q & A-9 through
13 and 19 were proposed in 1984, including the key employee
concentration test, statutory nontaxable benefits (enacted in the
Deficit Reduction Act of 1984 (DEFRA), Public Law 98-369, section
531(b), (98 Stat. 881(1984)), and the change in definition of dependent
in WFTRA.
The new proposed regulations provide additional guidance on the
cafeteria plan nondiscrimination rules, including definitions of key
terms, guidance on the eligibility test and the contributions and
benefits tests, descriptions of employees allowed to be excluded from
testing and a safe harbor nondiscrimination test for premium-only-
plans.
Specifically, the new proposed regulations define several key
terms, including highly compensated individual or participant
(consistent with the section 414(q) definition of highly compensated
employee), officer, five percent shareholder, key employee and
compensation. The new proposed regulations also provide guidance on the
nondiscrimination as to eligibility requirement by incorporating some
of the rules under section 410(b) (specifically the rules under Sec.
1.410(b)-4(b) and (c) dealing with reasonable classification, the safe
harbor percentage test and the unsafe harbor percentage component of
the facts and circumstances test).
The new proposed regulations also provide additional guidance on
the contributions and benefits test and, unlike the prior proposed
regulations, the new proposed regulations provide an objective test to
determine when the actual election of benefits is discriminatory.
Specifically, the new proposed regulations provide that a cafeteria
plan must give each similarly situated participant a uniform
opportunity to elect qualified benefits, and that highly compensated
participants must not actually disproportionately elect qualified
benefits. Finally, the new rules provide guidance on the safe harbor
for cafeteria plans providing health benefits and create a safe harbor
for premium-only-plans that satisfy certain requirements.
The example in Prop. Sec. 1.125-1, Q & A-11 (1984) is deleted
because it concerns a qualified legal services plan, which is no longer
a qualified benefit.
Other Issues
These proposed regulations provide guidance under section 125 (26
U.S.C. 125). Other statutes may impose additional requirements (for
example, the Employee Retirement Income Security Act of 1974 (ERISA)
(29 U.S.C. 1000), the Health Insurance Portability and Accountability
Act of 1996 (HIPAA), (sections 9801-9803); and the continuation
coverage requirements under the Consolidated Omnibus Budget
Reconciliation Act of 1985 (COBRA) (section 4980B).
Proposed Effective Date
With the exceptions noted in the ``Effect on other documents''
section of this preamble and under the ``Debit cards'' section of the
preamble, it is proposed that these regulations apply for plan years
beginning on or after January 1, 2009. Taxpayers may rely on these
regulations for guidance pending the issuance of final regulations.
Prior published guidance on qualified benefits under sections 79, 105,
106, 129, 137 and 223 that is affected by these proposed regulations
remains applicable through the effective date of the final regulations
(except as modified in ``Effect on other documents'' section of this
preamble).
Effect on Other Documents
Notice 89-110 (1989-2 CB 447), see Sec. 601.601(d)(2)(ii)(b),
states that where group-term life insurance provided to an employee by
an employer exceeds $50,000, the employee includes in gross income the
greater of the cost of group-term life insurance shown in Sec. 1.79-
3(d)(2), Table I (Table I ) on the excess coverage or the employee's
salary reduction and employer flex-credits for excess coverage. Notice
89-110 is modified, effective as of the date the proposed regulations
are published in the Federal Register.
Published guidance under Sec. 105(b) states that if any person has
the right to receive cash or any other taxable or nontaxable benefit
under a health FSA other than the reimbursement of section 213(d)
medical expenses of the employee, employee's spouse or employee's
dependents, then all distributions made from the arrangement are
included in the employee's gross income, even amounts paid to reimburse
medical care. See Rev. Rul. 2006-36 (2006-36 IRB 353); Rev. Rul. 2005-
24 (2005-1 CB 892); Rev. Rul. 2003-102 (2003-2 CB 559); Notice 2002-45
(2002-2 CB 93); Rev. Rul. 2002-41 (2002-2 CB 75); Rev. Rul. 69-141
(1969-1 CB 48). New section 106(e) provides that a health FSA will not
fail to satisfy the requirements of sections 105 or 106 merely because
the plan provides for a qualified HSA distribution. Amounts rolled into
an HSA may be used for purposes other than reimbursing the section
213(d) medical expenses of the employee, spouse or dependents.
Accordingly, Rev. Rul. 2006-36, Rev. Rul. 2005-24, Rev. Rul. 2003-102,
Notice 2002-45, Rev. Rul. 2002-41, and Rev. Rul. 69-141 are modified
with respect to qualified HSA distributions described in section
106(e). See Notice 2007-22 (2007-10 IRB 670), see Sec.
601.601(d)(2)(ii)(b).
Special Analyses
It has been determined that this notice of proposed rulemaking is
not a significant regulatory action as defined in Executive Order
12866. Therefore, a regulatory assessment is not required. It also has
been determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to this regulation. It is hereby
certified that the collection of information in this regulation will
not have a significant economic impact on a substantial
[[Page 43945]]
number of small entities. This certification is based on the fact that
the regulations will only minimally increase the burdens on small
entities. The requirements under these regulations relating to
maintaining a section 125 cafeteria plan are a minimal additional
burden independent of the burdens encompassed under existing rules for
underlying employee benefit plans, which exist whether or not the
benefits are provided through a cafeteria plan. In addition, most small
entities that will maintain cafeteria plans already use a third-party
plan administrator to administer the cafeteria plan. The collection of
information required in these regulations, which is required to comply
with the existing substantiation requirements of sections 105, 106, 129
and 125, and the recordkeeping requirements of section 6001, will only
minimally increase the third-party administrator's burden with respect
to the cafeteria plan. Therefore, an analysis under the Regulatory
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to
section 7805(f) of the Internal Revenue Code, this proposed regulation
has been submitted to the Chief Counsel for Advocacy of the Small
Business Administration for comment on its impact on small business.
Comments and Public Hearing
Before these proposed regulations are adopted as final regulations,
consideration will be given to any written comments (a signed original
and eight (8) copies) or electronic comments that are submitted timely
to the IRS. The IRS and Treasury Department specifically request
comments on the clarity of the proposed rules and how they can be made
easier to understand. In addition, comments are requested on the
following issues:
1. Whether, consistent with section 125 of the Internal Revenue
Code, multiple employers (other than members of a controlled group
described in section 125(g)(4)) may sponsor a single cafeteria plan;
2. Whether salary reduction contributions may be based on
employees' tips and how that would work;
3. For cafeteria plans adopting the change in status rules in Sec.
1.125-4, when a participant has a change in status and changes his or
her salary reduction amount, how should the participant's uniform
coverage amount be computed after the change in status.
All comments will be available for public inspection and copying.
A public hearing has been scheduled for November 15, 2007,
beginning at 10 a.m. in the Auditorium, Internal Revenue Service, 1111
Constitution Avenue, NW., Washington, DC. Due to building security
procedures, visitors must enter at the Constitution Avenue entrance. In
addition, all visitors must present photo identification to enter the
building. Because of access restrictions, visitors will not be admitted
beyond the immediate entrance area more than 30 minutes before the
hearing starts. For information about having your name placed on the
building access list to attend the hearing, see the FOR FURTHER
INFORMATION CONTACT section of this preamble.
The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who
wish to present oral comments at the hearing must submit written or
electronic comments and an outline of the topics to be discussed and
the amount of time to be devoted to each topic (a signed original and
eight (8) copies) by October 25, 2007. A period of 10 minutes will be
allotted to each person for making comments. An agenda showing the
scheduling of the speakers will be prepared after the deadline for
receiving outlines has passed. Copies of the agenda will be available
free of charge at the hearing.
Drafting Information
The principal author of these proposed regulations is Mireille T.
Khoury, Office of Division Counsel/Associate Chief Counsel (Tax Exempt
and Government Entities), Internal Revenue Service. However, personnel
from other offices of the IRS and Treasury Department participated in
their development.
List of Subjects in 26 CFR Part 1
Income taxes, Reporting and recordkeeping requirements.
Withdrawal of Proposed Regulations
Accordingly, under the authority of 26 U.S.C. 7805, the notice of
proposed rulemaking (EE-16-79) that was published in the Federal
Register on Monday, May 7, 1984 (49 FR 19321), and Monday, December 31,
1984 (49 FR 50733), the notice of proposed rulemaking (EE-130-86) that
was published in the Federal Register on Tuesday, March 7, 1989 (54 FR
9460), and Friday, November 7, 1997 (62 FR 60196) and the notice of
proposed rulemaking (REG-117162-99) that was published in the Federal
Register on Thursday, March 23, 2000 (65 FR 15587) are withdrawn.
Proposed Amendment to the Regulations
Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAXES
Paragraph 1. The authority citation for part 1 continues to read,
in part, as follows:
Authority: 26 U.S.C. 7805 * * *
Par. 2. Sections 1.125-0, 1.125-1 and 1.125-2 are added to read as
follows:
Sec. 1.125-0 Table of contents.
This section lists captions contained in Sec. Sec. 1.125-1, 1.125-
2, 1.125-5, 1.125-6 and Sec. 1.125-7.
Sec. 1.125-1 Cafeteria plans; general rules.
(a) Definitions.
(b) General rules.
(c) Written plan requirements.
(d) Plan year requirements.
(e) Grace period.
(f) Run-out period.
(g) Employee for purpose of Section 125.
(h) After-tax employee contributions.
(i) Prohibited taxable benefits.
(j) Coordination with other rules.
(k) Group-term life insurance.
(l) COBRA premiums.
(m) Payment or reimbursement of employees' individual accident and
health insurance premiums.
(n) Section 105 rules for accident and health plan offered through a
cafeteria plan.
(o) Prohibition against deferred compensation.
(p) Benefits relating to more than one year.
(q) Nonqualified benefits.
(r) Employer contributions to a cafeteria plan.
(s) Effective/applicability date.
Sec. 1.125-2 Cafeteria plans; elections.
(a) Rules relating to making elections and revoking elections.
(b) Automatic elections.
(c) Election rules for salary reduction contributions to HSAs.
(d) Optional election for new employees.
(e) Effective/applicability date.
Sec. 1.125-5 Flexible spending arrangements.
(a) Definition of flexible spending arrangement.
(b) Flex-credits allowed.
(c) Use-or-lose rule.
(d) Uniform coverage rules applicable to health FSAs.
(e) Required period of coverage for a health FSA, dependent care FSA
and adoption assistance FSA.
(f) Coverage on a month-by-month or expense-by-expense basis
prohibited.
(g) FSA administrative practices.
(h) Qualified benefits permitted to be offered through a FSA.
(i) Section 129 rules for dependent care assistance program offered
through a cafeteria plan.
(j) Section 137 rules for adoption assistance program offered
through a cafeteria plan.
(k) FSAs and the rules governing the tax-favored treatment of
employer-provided health benefits.
(l) Section 105(h) requirements.
(m) HSA-compatible FSAs-limited-purpose health FSAs and post-
deductible health FSAs.
[[Page 43946]]
(n) Qualified HSA distributions.
(o) FSA experience gains or forfeitures.
(p) Effective/applicability date.
Sec. 1.125-6 Substantiation of expenses for all cafeteria plans.
(a) Cafeteria plan payments and reimbursements.
(b) Rules for claims substantiation for cafeteria plans.
(c) Debit cards--overview.
(d) Mandatory rules for all debit cards usable to pay or reimburse
medical expenses.
(e) Substantiation of expenses incurred at medical care providers
and certain other stores with Drug Stores and Pharmacies merchant
category code.
(f) Inventory information approval system.
(g) Debit cards used to pay or reimburse dependent care assistance.
(h) Effective/applicability date.
Sec. 1.125-7 Cafeteria plan nondiscrimination rules.
(a) Definitions.
(b) Nondiscrimination as to eligibility.
(c) Nondiscrimination as to contributions and benefits.
(d) Key employees.
(e) Section 125(g)(2) safe harbor for cafeteria plans providing
health benefits.
(f) Safe harbor test for premium-only-plans.
(g) Permissive disaggregation for nondiscrimination testing.
(h) Optional aggregation of plans for nondiscrimination testing.
(i) Employees of certain controlled groups.
(j) Time to perform nondiscrimination testing.
(k) Discrimination in actual operation prohibited.
(l) Anti-abuse rule.
(m) Tax treatment of benefits in a cafeteria plan.
(n) Employer contributions to employees' Health Savings Accounts.
(o) Effective/applicability date.
Sec. 1.125-1 Cafeteria plans; general rules.
(a) Definitions. The definitions set forth in this paragraph (a)
apply for purposes of section 125 and the regulations.
(1) The term cafeteria plan means a separate written plan that
complies with the requirements of section 125 and the regulations, that
is maintained by an employer for the benefit of its employees and that
is operated in compliance with the requirements of section 125 and the
regulations. All participants in a cafeteria plan must be employees. A
cafeteria plan must offer at least one permitted taxable benefit (as
defined in paragraph (a)(2) of this section) and at least one qualified
benefit (as defined in paragraph (a)(3) of this section). A cafeteria
plan must not provide for deferral of compensation (except as
specifically permitted in paragraph (o) of this section).
(2) The term permitted taxable benefit means cash and certain other
taxable benefits treated as cash for purposes of section 125. For
purposes of section 125, cash means cash compensation (including salary
reduction), payments for annual leave, sick leave, or other paid time
off and severance pay. A distribution from a trust described in section
401(a) is not cash for purposes of section 125. Other taxable benefits
treated as cash for purposes of section 125 are:
(i) Property;
(ii) Benefits attributable to employer contributions that are
currently taxable to the employee upon receipt by the employee; and
(iii) Benefits purchased with after-tax employee contributions, as
described in paragraph (h) of this section.
(3) Qualified benefit. Except as otherwise provided in section
125(f) and paragraph (q) of this section, the term qualified benefit
means any benefit attributable to employer contributions to the extent
that such benefit is not currently taxable to the employee by reason of
an express provision of the Internal Revenue Code (Code) and which does
not defer compensation (except as provided in paragraph (o) of this
section). The following benefits are qualified benefits that may be
offered under a cafeteria plan and are excludible from employees' gross
income when provided in accordance with the applicable provisions of
the Code--
(A) Group-term life insurance on the life of an employee in an
amount that is less than or equal to the $50,000 excludible from gross
income under section 79(a), but not combined with any permanent benefit
within the meaning of Sec. 1.79-0;
(B) An accident and health plan excludible from gross income under
section 105 or 106, including self-insured medical reimbursement plans
(such as health FSAs described in Sec. 1.125-5);
(C) 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;
(D) An accidental death and dismemberment insurance policy (section
106);
(E) Long-term or short-term disability coverage (section 106);
(F) Dependent care assistance program (section 129);
(G) Adoption assistance (section 137);
(H) A qualified cash or deferred arrangement that is part of a
profit-sharing plan or stock bonus plan, as described in paragraph
(o)(3) of this section (section 401(k));
(I) Certain plans maintained by educational organizations (section
125(d)(2)(C) and paragraph (o)(3)(iii) of this section); and
(J) Contributions to Health Savings Accounts (HSAs) (sections 223
and 125(d)(2)(D)).
(4) Dependent. The term dependent generally means a dependent as
defined in section 152. However, the definition of dependent is
modified to conform with the underlying Code section for the qualified
benefit. For example, for purposes of a benefit under section 105, the
term dependent means a dependent as defined in section 152, determined
without regard to section 152(b)(1), (b)(2) or (d)(1)(B).
(5) Premium-only-plan. A premium-only-plan is a cafeteria plan that
offers as its sole benefit an election between cash (for example,
salary) and payment of the employee share of the employer-provided
accident and health insurance premium (excludible from the employee's
gross income under section 106).
(b) General rules--(1) Cafeteria plans. Section 125 is the
exclusive means by which an employer can offer employees an election
between taxable and nontaxable benefits without the election itself
resulting in inclusion in gross income by the employees. Section 125
provides that cash (including certain taxable benefits) offered to an
employee through a nondiscriminatory cafeteria plan is not includible
in the employee's gross income merely because the employee has the
opportunity to choose among cash and qualified benefits (within the
meaning of section 125(e)) through the cafeteria plan. Section 125(a),
(d)(1). However, if a plan offering an employee an election between
taxable benefits (including cash) and nontaxable qualified benefits
does not meet the section 125 requirements, the election between
taxable and nontaxable benefits results in gross income to the
employee, regardless of what benefit is elected and when the election
is made. An employee who has an election among nontaxable benefits and
taxable benefits (including cash) that is not through a cafeteria plan
that satisfies section 125 must include in gross income the value of
the taxable benefit with the greatest value that the employee could
have elected to receive, even if the employee elects to receive only
the nontaxable benefits offered. The amount of the taxable benefit is
includible in the
[[Page 43947]]
employee's income in the year in which the employee would have actually
received the taxable benefit if the employee had elected such benefit.
This is the result even if the employee's election between the
nontaxable benefits and taxable benefits is made prior to the year in
which the employee would actually have received the taxable benefits.
See paragraph (q) in Sec. 1.125-1 for nonqualified benefits.
(2) Nondiscrimination rules for qualified benefits. Accident and
health plan coverage, group-term life insurance coverage, and benefits
under a dependent care assistance program or adoption assistance
program do not fail to be qualified benefits under a cafeteria plan
merely because they are includible in gross income because of
applicable nondiscrimination requirements (for example, sections 79(d),
105(h),129(d), 137(c)(2)). See also Sec. Sec. 1.105-11(k) and 1.125-7.
(3) Examples. The following examples illustrate the rules of
paragraph (b)(1) of this section.
Example 1. Distributions from qualified pension plan used for
health insurance premiums. (i) Employer A maintains a qualified
section 401(a) retirement plan for employees. Employer A also
provides accident and health insurance (as described in section 106)
for employees and former employees, their spouses and dependents.
The health insurance premiums are partially paid through a cafeteria
plan. None of Employer A's employees are public safety officers.
Employer A's health plan allows former employees to elect to have
distributions from the qualified retirement plan applied to pay for
the health insurance premiums through the cafeteria plan.
(ii) Amounts distributed from the qualified retirement plan
which the former employees elect to have applied to pay health
insurance premiums through the cafeteria plan are includible in
their gross income. The same result occurs if distributions from the
qualified retirement plan are applied directly to reimburse section
213(d) medical care expenses incurred by a former employee or his or
her spouse or dependents. These distributions are includible in
their income, and are not cash for purposes of section 125. The plan
is not a cafeteria plan with respect to former employees.
Example 2. Severance pay used to pay COBRA premiums. Employer B
maintains a cafeteria plan, which offers employees an election
between cash and employer-provided accident and health insurance
(excludible from employees' gross income under section 106).
Employer B pays terminating employees severance pay. The cafeteria
plan also allows a terminating employee to elect between receiving
severance pay and using the severance pay to pay the COBRA premiums
for the accident and health insurance. These provisions in the
cafeteria plan are consistent with the requirements in section 125.
(4) Election by participants--(i) In general. A cafeteria plan must
offer participants the opportunity to elect between at least one
permitted taxable benefit and at least one qualified benefit. For
example, if employees are given the opportunity to elect only among two
or more nontaxable benefits, the plan is not a cafeteria plan.
Similarly, a plan that only offers the election among salary, permitted
taxable benefits, paid time off or other taxable benefits is not a
cafeteria plan. See section 125(a), (d). See Sec. 1.125-2 for rules on
elections.
(ii) Premium-only-plan. A cafeteria plan may be a premium-only-
plan.
(iii) Examples. The following examples illustrate the rules of
paragraph (b)(4)(i) of this section.
Example 1. No election. Employer C covers all its employees
under its accident and health plan (excludible from employees' gross
income under section 106). Coverage is mandatory (that is, employees
have no election between cash and the Employer C's accident and
health plan). This plan is not a cafeteria plan, because the plan
offers employees no election between taxable and nontaxable
benefits. The accident and health coverage is excludible from
employees' gross income.
Example 2. Election between cash and at least one qualified
benefit. Employer D offers its employees a plan with an election
between cash and an employer-provided accident and health plan
(excludible from employees' gross income under section 106). If the
plan also satisfies all the other requirements of section 125, the
plan is a cafeteria plan because it offers an election between at
least one taxable benefit and at least one nontaxable qualified
benefit.
Example 3. Election between employer flex-credits and qualified
benefits. Employer E offers its employees an election between an
employer flex-credit (as defined in paragraph (b) in Sec. 1.125-5)
and qualified benefits. If an employee does not elect to apply the
entire employer flex-credit to qualified benefits, the employee will
receive no cash or other taxable benefit for the unused employer
flex-credit. The plan is not a cafeteria plan because it does not
offer an election between at least one taxable benefit and at least
one nontaxable qualified benefit.
Example 4. No election between cash and qualified benefits for
certain employees. (i) Employer F maintains a calendar year plan
offering employer-provided accident and health insurance coverage
which includes employee-only and family coverage options.
(ii) The plan provides for an automatic enrollment process when
a new employee is hired, or during the annual election period under
the plan: only employees who certify that they have other health
coverage are permitted to elect to receive cash. Employees who
cannot certify are covered by the accident and health insurance on a
mandatory basis. Employer F does not otherwise request or collect
information from employees regarding other health coverage as part
of the enrollment process. If the employee has a spouse or child,
the employee can elect between cash and family coverage.
(iii) When an employee is hired, the employee receives a notice
explaining the plan's automatic enrollment process. The notice
includes the salary reduction amounts for employee-only coverage and
family coverage, procedures for certifying whether the employee has
other health coverage, elections for family coverage, information on
the time by which a certification or election must be made, and the
period for which a certification or election will be effective. The
notice is also given to each current employee before the beginning
of each plan year, (except that the notice for a current employee
includes a description of the employee's existing coverage, if any).
(iv) For a new employee, an election to receive cash or to have
family coverage is effective if made when the employee is hired. For
a current employee, an election is effective if made prior to the
start of each calendar year or under any other circumstances
permitted under Sec. 1.125-4. An election for any prior year
carries over to the next succeeding plan year unless changed.
Certification that the employee has other health coverage must be
made annually.
(v) Contributions used to purchase employer-provided accident
and health coverage under section 125 are not includible in an
employee's gross income if the employee can elect cash. Section 125
does not apply to the employee-only coverage of an employee who
cannot certify that he or she has other health coverage and,
therefore, does not have the ability to elect cash in lieu of health
coverage.
(5) No deferred compensation. Except as provided in paragraph (o)
of this section, in order for a plan to be a cafeteria plan, the
qualified benefits and the permitted taxable benefits offered through
the cafeteria plan must not defer compensation. For example, a
cafeteria plan may not provide for retirement health benefits for
current employees beyond the current plan year or group-term life
insurance with a permanent benefit, as defined under Sec. 1.79-0.
(c) Written plan requirements--(1) General rule. A cafeteria plan
must contain in writing the information described in this paragraph
(c), and depending on the qualified benefits offered in the plan, may
also be required to contain additional information described in
paragraphs (c)(2) and (c)(3) of this section. The cafeteria plan must
be adopted and effective on or before the first day of the cafeteria
plan year to which it relates. The terms of the plan must apply
uniformly to all participants. The cafeteria plan document may be
comprised of multiple documents. The written cafeteria plan must
contain all of the following information--
[[Page 43948]]
(i) A specific description of each of the benefits available
through the plan, including the periods during which the benefits are
provided (the periods of coverage);
(ii) The plan's rules governing participation, and specifically
requiring that all participants in the plan be employees;
(iii) 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 optional change in
status rules in Sec. 1.125-4 are included in the cafeteria plan;
(iv) The manner in which employer contributions may be made under
the plan, (for example, through an employee's salary reduction election
or by nonelective employer contributions (that is, flex-credits, as
defined in paragraph (b) in Sec. 1.125-5) or both);
(v) The maximum amount of employer contributions available to any
employee through the plan, by stating:
(A) The maximum amount of elective contributions (i.e., salary
reduction) available to any employee through the plan, expressed as a
maximum dollar amount or a maximum percentage of compensation or the
method for determining the maximum dollar amount; and
(B) For contributions to section 401(k) plans, the maximum amount
of elective contributions available to any employee through the plan,
expressed as a maximum dollar amount or maximum percentage of
compensation that may be contributed as elective contributions through
the plan by employees.
(vi) The plan year of the cafeteria plan;
(vii) If the plan offers paid time off, the required ordering rule
for use of nonelective and elective paid time off in paragraph (o)(4)
of this section;
(viii) If the plan includes flexible spending arrangements (as
defined in Sec. 1.125-5(a)), the plan's provisions complying with any
additional requirements for those FSAs (for example, the uniform
coverage rule and the use-or-lose rules in paragraphs (d) and (c) in
Sec. 1.125-5);
(ix) If the plan includes a grace period, the plan's provisions
complying with paragraph (e) of this section; and
(x) If the plan includes distributions from a health FSA to
employees' HSAs, the plan's provisions complying with paragraph (n) in
Sec. 1.125-5.
(2) Additional requirements under sections 105(h), 129, and 137. A
written plan is required for self-insured medical reimbursement plans
(Sec. 1.105-11(b)(1)(i)), dependent care assistance programs (section
129(d)(1)), and adoption assistance (section 137(c)). Any of these
plans or programs offered through a cafeteria plan that satisfies the
written plan requirement in this paragraph (c) for the benefits under
these plans and programs also satisfies the written plan requirements
in Sec. 1.105-11(b)(1)(i), section 129(d)(1), and section 137(c)
(whichever is applicable). Alternatively, a self-insured medical
reimbursement plan, a dependent care assistance program, or an adoption
assistance program is permitted to satisfy the requirements in Sec.
1.105-11(b)(1)(i), section 129(d)(1), or section 137(c) (whichever is
applicable) through a separate written plan, and not as part of the
written cafeteria plan.
(3) Additional requirements under section 401(k). See Sec.
1.401(k)-1(e)(7) for additional requirements that must be satisfied in
the written plan if the plan offers deferrals into a section 401(k)
plan.
(4) Cross-reference allowed. In describing the benefits available
through the cafeteria plan, the written cafeteria plan need not be
self-contained. For example, the written cafeteria plan may incorporate
by reference benefits offered through other separate written plans,
such as a section 401(k) plan, or coverage under a dependent care
assistance program (section 129), without describing in full the
benefits established through these other plans. But, for example, if
the cafeteria plan offers different maximum levels of coverage for
dependent care assistance programs, the descriptions in the separate
written plan must specify the available maximums.
(5) Amendments to cafeteria plan. Any amendment to the cafeteria
plan must be in writing. A cafeteria plan is permitted to be amended at
any time during a plan year. However, the amendment is only permitted
to be effective for periods after the later of the adoption date or
effective date of the amendment. For an amendment adding a new benefit,
the cafeteria plan must pay or reimburse only those expenses for new
benefits incurred after the later of the amendment's adoption date or
effective date.
(6) Failure to satisfy written plan requirements. If there is no
written cafeteria plan, or if the written plan fails to satisfy any of
the requirements in this paragraph (c) (including cross-referenced
requirements), the plan is not a cafeteria plan and an employee's
election between taxable and nontaxable benefits results in gross
income to the employee.
(7) Operational failure--(i) In general. If the cafeteria plan
fails to operate according to its written plan or otherwise fails to
operate in compliance with section 125 and the regulations, the plan is
not a cafeteria plan and employees' elections between taxable and
nontaxable benefits result in gross income to the employees.
(ii) Failure to operate according to written cafeteria plan or
section 125. Examples of failures resulting in section 125 not applying
to a plan include the following--
(A) Paying or reimbursing expenses for qualified benefits incurred
before the later of the adoption date or effective date of the
cafeteria plan, before the beginning of a period of coverage or before
the later of the date of adoption or effective date of a plan amendment
adding a new benefit;
(B) Offering benefits other than permitted taxable benefits and
qualified benefits;
(C) Operating to defer compensation (except as permitted in
paragraph (o) of this section);
(D) Failing to comply with the uniform coverage rule in paragraph
(d) in Sec. 1.125-5;
(E) Failing to comply with the use-or-lose rule in paragraph (c) in
Sec. 1.125-5;
(F) Allowing employees to revoke elections or make new elections,
except as provided in Sec. 1.125-4 and paragraph (a) in Sec. 1.125-2;
(G) Failing to comply with the substantiation requirements of Sec.
1.125-6;
(H) Paying or reimbursing expenses in an FSA other than expenses
expressly permitted in paragraph (h) in Sec. 1.125-5;
(I) Allocating experience gains other than as expressly permitted
in paragraph (o) in Sec. 1.125-5;
(J) Failing to comply with the grace period rules in paragraph (e)
of this section; or
(K) Failing to comply with the qualified HSA distribution rules in
paragraph (n) in Sec. 1.125-5.
(d) Plan year requirements--(1) Twelve consecutive months. The plan
year must be specified in the cafeteria plan. The plan year of a
cafeteria plan must be twelve consecutive months, unless a short plan
year is allowed under this paragraph (d). A plan year is permitted to
begin on any day of any calendar month and must end on the preceding
day in the immediately following year (for example, a plan year that
begins on October 15, 2007, must end on October 14, 2008). A calendar
year plan year is a period of twelve consecutive months beginning on
January 1 and ending on December 31 of the same calendar year. A plan
year
[[Page 43949]]
specified in the cafeteria plan is effective for the first plan year of
a cafeteria plan and for all subsequent plan years, unless changed as
provided in paragraph (d)(2) of this section.
(2) Changing plan year. The plan year is permitted to be changed
only for a valid business purpose. A change in the plan year is not
permitted if a principal purpose of the change in plan year is to
circumvent the rules of section 125 or these regulations. If a change
in plan year does not satisfy this subparagraph, the attempt to change
the plan year is ineffective and the plan year of the cafeteria plan
remains the same.
(3) Short plan year. A short plan year of less than twelve
consecutive months is permitted for a valid business purpose.
(4) Examples. The following examples illustrate the rules in
paragraph (d) of this section:
Example 1. Employer with calendar year. Employer G, with a
calendar taxable year, first establishes a cafeteria plan effective
July 1, 2009. The cafeteria plan specifies a calendar plan year. The
first cafeteria plan year is the period beginning on July 1, 2009,
and ending on December 31, 2009. Employer G has a business purpose
for a short first cafeteria plan year.
Example 2. Employer changes insurance carrier. Employer H
establishes a cafeteria plan effective January 1, 2009, with a
calendar year plan year. The cafeteria plan offers an accident and
health plan through Insurer X. In March 2010, Employer H contracts
to provide accident and health insurance through another insurance
company, Y. Y's accident and health insurance is offered on a July
1-June 30 benefit year. Effective July 1, 2010, Employer H amends
the plan to change to a July 1-June 30 plan year. Employer H has a
business purpose for changing the cafeteria plan year and for the
short plan year ending June 30, 2010.
(5) Significance of plan year. The plan year generally is the
coverage period for benefits provided through the cafeteria plan to
which annual elections for these benefits apply. Benefits elected
pursuant to the employee's election for a plan year generally may not
be carried forward to subsequent plan years. However, see the grace
period rule in paragraph (e) of this section.
(e) Grace period--(1) In general. A cafeteria plan may, at the
employer's option, include a grace period of up to the fifteenth day of
the third month immediately following the end of each plan year. If a
cafeteria plan provides for a grace period, an employee who has unused
benefits or contributions relating to a qualified benefit (for example,
health flexible spending arrangement (health FSA) or dependent care
assistance) from the immediately preceding plan year, and who incurs
expenses for that same qualified benefit during the grace period, may
be paid or reimbursed for those expenses from the unused benefits or
contributions as if the expenses had been incurred in the immediately
preceding plan year. A grace period is available for all qualified
benefits described in paragraph (a)(3) of this section, except that the
grace period does not apply to paid time off and elective contributions
under a section 401(k) plan. The effect of the grace period is that the
employee may have as long as 14 months and 15 days (that is, the 12
months in the current cafeteria plan year plus the grace period) to use
the benefits or contributions for a plan year before those amounts are
forfeited under the use-or-lose rule in paragraph (c) in Sec. 1.125-5.
If the grace period is added to a cafeteria plan through an amendment,
all requirements in paragraph (c) of this section must be satisfied.
(2) Grace period optional features. A grace period provision may
contain any or all of the following--
(i) The grace period may apply to some qualified benefits described
in paragraph (a)(3) of this section, but not to others;
(ii) The grace period provision may limit the amount of unused
benefits or contributions available during the grace period. The limit
must be uniform and apply to all participants. However, the limit must
not be based on a percentage of the amount of the unused benefits or
contributions remaining at the end of the immediately prior plan year;
(iii) The last day of the grace period may be sooner than the
fifteenth day of the third month immediately following the end of the
plan year (that is, the grace period may be shorter than two and one
half months);
(iv) The grace period provision is permitted to treat expenses for
qualified benefits incurred during the grace period either as expenses
incurred during the immediately preceding plan year or as expenses
incurred during the current plan year (for example, the plan may first
apply the unused contributions or benefits from the immediately
preceding year to pay or reimburse grace period expenses and then, when
the unused contributions and benefits from the prior year are
exhausted, the grace period expenses may be paid from current year
contributions and benefits.); and
(v) The grace period provision may permit the employer to defer the
allocation of expenses described in paragraph (e)(2)(iv) of this
section until after the end of the grace period.
(3) Grace period requirements. A grace period must satisfy the
requirements in paragraph (c) of this section and all of the following
requirements:
(i) The grace period provisions in the cafeteria plan (including
optional provisions in paragraph (e)(2) of this section) must apply
uniformly to all participants in the cafeteria plan, determined as of
the last day of the plan year. Participants in the cafeteria plan
through COBRA and participants who were participants as of the last day
of the plan year but terminate during the grace period are participants
for purposes of the grace period. See Sec. 54.4980B-2, Q & A-8 of this
chapter;
(ii) The grace period provision in the cafeteria plan must state
that unused benefits or contributions relating to a particular
qualified benefit may only be used to pay or reimburse expenses
incurred with respect to the same qualified benefit. For example,
unused amounts elected to pay or reimburse medical expenses in a health
FSA may not be used to pay or reimburse dependent care expenses
incurred during the grace period; and
(iii) The grace period provision in the cafeteria plan must state
that to the extent any unused benefits or contributions from the
immediately preceding plan year exceed the expenses for the qualified
benefit incurred during the grace period, those remaining unused
benefits or contributions may not be carried forward to any subsequent
period (including any subsequent plan year), cannot be cashed-out and
must be forfeited under the use-or-lose rule. See paragraph (c) in
Sec. 1.125-5
(4) Examples. The following examples illustrate the rules in this
paragraph (e).
Example 1. Expenses incurred during grace period and immediately
following plan year. (i) Employer I's calendar year cafeteria plan
includes a grace period allowing all participants to apply unused
benefits or contributions remaining at the end of the plan year to
qualified benefits incurred during the grace period immediately
following that plan year. The grace period for the plan year ending
December 31, 2009, ends on March 15, 2010.
(ii) Employee X timely elected salary reduction of $1,000 for a
health FSA for the plan year ending December 31, 2009. As of
December 31, 2009, X has $200 remaining unused in his health FSA. X
timely elected salary reduction for a health FSA of $1,500 for the
plan year ending December 31, 2010.
(iii) During the grace period from January 1 through March 15,
2010, X incurs $300 of unreimbursed medical expenses (as defined in
section 213(d)). The unused $200 from the plan year ending December
31, 2009, is applied to pay or reimburse $200 of X's $300 of medical
expenses incurred during the grace period. Therefore, as of March
16, 2010, X has no unused benefits or contributions
[[Page 43950]]
remaining for the plan year ending December 31, 2009.
(iv) The remaining $100 of medical expenses incurred between
January 1 and March 15, 2010, is paid or reimbursed from X's health
FSA for the plan year ending December 31, 2010. As of March 16,
2010, X has $1,400 remaining in the health FSA for the plan year
ending December 31, 2010.
Example 2. Unused benefits exceed expenses incurred during grace
period. Same facts as Example 1, except that X incurs $150 of
section 213(d) medical expenses during the grace period (January 1
through March 15, 2010). As of March 16, 2010, X has $50 of unused
benefits or contributions remaining for the plan year ending
December 31, 2009. The unused $50 cannot be cashed-out, converted to
any other taxable or nontaxable benefit, or used in any other plan
year (including the plan year ending December 31, 2009). The unused
$50 is subject to the use-or-lose rule in paragraph (c) in Sec.
1.125-5 and is forfeited. As of March 16, 2010, X has the entire
$1,500 elected in the health FSA for the plan year ending December
31, 2010.
Example 3. Terminated participants. (i) Employer J's cafeteria
plan includes a grace period allowing all participants to apply
unused benefits or contributions remaining at the end of the plan
year to qualified benefits incurred during the grace period
immediately following that plan year. For the plan year ending on
December 31, 2009, the grace period ends March 15, 2010.
(ii) Employees A, B, C, and D each timely elected $1,200 salary
reduction for a health FSA for the plan year ending December 31,
2009. Employees A and B terminated employment on September 15, 2009.
Each has $500 of unused benefits or contributions in the health FSA.
(iii) Employee A elected COBRA for the health FSA. Employee A is
a participant in the cafeteria plan as of December 31, 2009, the
last day of the 2009 plan year. Employee A has $500 of unused
benefits or contributions available during the grace period for the
2009 plan year (ending March 15, 2010).
(iv) Employee B did not elect COBRA for the health FSA. Employee
B is not a participant in the cafeteria plan as of December 31,
2009. The grace period does not apply to Employee B.
(v) Employee C has $500 of unused benefits in his health FSA as
of December 31, 2009, and terminated employment on January 15, 2010.
Employee C is a participant in the cafeteria plan as of December 31,
2009 and has $500 of unused benefits or contributions available
during the grace period ending March 15, 2010, even though he
terminated employment on January 15, 2010.
(vi) Employee D continues to work for Employer H throughout 2009
and 2010, also has $500 of unused benefits or contributions in his
health FSA as of December 31, 2009, but made no health FSA election
for 2010. Employee D is a participant in the cafeteria plan as of
December 31, 2009 and has $500 of unused benefits or contributions
available during the grace period ending March 15, 2010, even though
he is not a participant in a health FSA for the 2010 plan year.
(f) Run-out period. A cafeteria plan is permitted to contain a run-
out period as designated by the employer. A run-out period is a period
after the end of the plan year (or grace period) during which a
participant can submit a claim for reimbursement for a qualified
benefit incurred during the plan year (or grace period). Thus, a plan
is also permitted to provide a deadline on or after the end of the plan
year (or grace period) for submitting a claim for reimbursement for the
plan year. Any run-out period must be provided on a uniform and
consistent basis with respect to all participants.
(g) Employee for purposes of section 125--(1) Current employees,
former employees. The term employee includes any current or former
employee (including any laid-off employee or retired employee) of the
employer. See paragraph (g)(3) of this section concerning limits on
participation by former employees. Specifically, the term employee
includes the following--
(i) Common law employee;
(ii) Leased employee described in section 414(n);
(iii) Full-time life insurance salesman (as defined in section
7701(a)(20)); and
(iv) A current employee or former employee described in paragraphs
(g)(1)(i) through (iii) of this section.
(2) Self-employed individual not an employee--(i) In general. The
term employee does not include a self-employed individual or a 2-
percent shareholder of an S corporation, as defined in paragraph
(g)(2)(ii) of this subsection. For example, a sole proprietor, a
partner in a partnership, or a director solely serving on a
corporation's board of directors (and not otherwise providing services
to the corporation as an employee) is not an employee for purposes of
section 125, and thus is not permitted to participate in a cafeteria
plan. However, a sole proprietor may sponsor a cafeteria plan covering
the sole proprietor's employees (but not the sole proprietor).
Similarly, a partnership or S corporation may sponsor a cafeteria plan
covering employees (but not a partner or 2-percent shareholder of an S
corporation).
(ii) Two percent shareholder of an S corporation. A 2-percent
shareholder of an S corporation has the meaning set forth in section
1372(b).
(iii) Certain dual status individuals. If an individual is an
employee of an employer and also provides services to that employer as
an independent contractor or director (for example, an individual is
both a director and an employee of a C corp), the individual is
eligible to participate in that employer's cafeteria plan solely in his
or her capacity as an employee. This rule does not apply to partners or
to 2-percent shareholders of an S corporation.
(iv) Examples. The following examples illustrate the rules in
paragraphs (g)(2)(ii) and (g)(2)(iii) of this section:
Example 1. Two-percent shareholders of an S corporation. (i)
Employer K, an S corporation, maintains a cafeteria plan for its
employees (other than 2-percent shareholders of an S corporation).
Employer K's taxable year and the plan year are the calendar year.
On January 1, 2009, individual Z owns 5 percent of the outstanding
stock in Employer K. Y, who owns no stock in Employer K, is married
to Z. Y and Z are employees of Employer K. Z is a 2-percent
shareholder in Employer K (as defined in section 1372(b)). Y is also
a 2-percent shareholder in Employer K by operation of the
attribution rules in section 318(a)(1)(A)(i).
(ii) On July 15, 2009, Z sells all his stock in Employer K to an
unrelated third party, and ceases to be a 2-percent shareholder. Y
and Z continue to work as employees of Employer K during the entire
2009 calendar year. Y and Z are ineligible to participate in
Employer K's cafeteria plan for the 2009 plan year.
Example 2. Director and employee. T is an employee and also a
director of Employer L, a C corp that sponsors a cafeteria plan. The
cafeteria plan allows only employees of Employer L to participate in
the cafeteria plan. T's annual compensation as an employee is
$50,000; T is also paid $3,000 annually in director's fees. T makes
a timely election to salary reduce $5,000 from his employee
compensation for dependent care benefits. T makes no election with
respect to his compensation as a director. T may participate in the
cafeteria plan in his capacity as an employee of Employer L.
(3) Limits on participation by former employees. Although former
employees are treated as employees, a cafeteria plan may not be
established or maintained predominantly for the benefit of former
employees of the employer. Such a plan is not a cafeteria plan.
(4) No participation by the spouse or dependent of an employee--(i)
Benefits allowed to participant's spouse or dependents but not
participation. The spouse or dependents of employees may not be
participants in a cafeteria plan unless they are also employees.
However, a cafeteria plan may provide benefits to spouses and
dependents of participants. For example, although an employee's spouse
may benefit from the employee's election of accident and health
insurance coverage or of coverage through a dependent care assistance
program, the spouse may not participate in a cafeteria plan (that is,
the spouse may not be given the opportunity to elect or purchase
benefits offered by the plan).
[[Page 43951]]
(ii) Certain elections after employee's death. An employee's spouse
is not a participant in a cafeteria plan merely because the spouse has
the right, upon the death of the employee, to elect among various
settlement options or to elect among permissible distribution options
with respect to the deceased employee's benefits through a section
401(k) plan, Health Savings Account, or certain group-term life
insurance offered through the cafeteria plan. See Sec. 54.4980B-2, Q &
A 8 and Sec. 54.4980B-4, Q & A-1 of this chapter on COBRA rights of a
participant's spouse or dependents.
(5) Employees of certain controlled groups. All employees who are
treated as employed by a single employer under section 414(b), (c),
(m), or (o) are treated as employed by a single employer for purposes
of section 125. Section 125(g)(4); section 414(t).
(h) After-tax employee contributions--(1) Certain after-tax
employee contributions treated as cash. In addition to the cash
benefits described in paragraph (a)(2) of this section, in general, a
benefit is treated as cash for purposes of section 125 if the benefit
does not defer compensation (except as provided in paragraph (o) of
this section) and an employee who receives the benefit purchases such
benefit with after-tax employee contributions or is treated, for all
purposes under the Code (including, for example, reporting and
withholding purposes), as receiving, at the time that the benefit is
received, cash compensation equal to the full value of the benefit at
that time and then purchasing the benefit with after-tax employee
contributions. Thus, for example, long-term disability coverage is
treated as cash for purposes of section 125 if the cafeteria plan
provides that an employee may purchase the coverage through the
cafeteria plan with after-tax employee contributions or provides that
the employee receiving such coverage is treated as having received cash
compensation equal to the value of the coverage and then as having
purchased the coverage with after-tax employee contributions. Also, for
example, a cafeteria plan may offer employees the opportunity to
purchase, with after-tax employee contributions, group-term life
insurance on the life of an employee (providing no permanent benefits),
an accident and health plan, or a dependent care assistance program.
(2) Accident and health coverage purchased for someone other than
the employee's spouse or dependents with after-tax employee
contributions. If the requirements of section 106 are satisfied,
employer-provided accident and health coverage for an employee and his
or her spouse or dependents is excludible from the employee's gross
income. The fair market value of coverage for any other individual,
provided with respect to the employee, is includible in the employee's
gross income. Sec. 1.106-1; Sec. 1.61-21(a)(4), and Sec. 1.61-
21(b)(1). A cafeteria plan is permitted to allow employees to elect
accident and health coverage for an individual who is not the spouse or
dependent of the employee as a taxable benefit.
(3) Example. The following example illustrates the rules of this
paragraph (h):
Example. Accident and health plan coverage for individuals who
are not a spouse or dependent of an employee. (i) Employee C
participates in Employer M's cafeteria plan. Employee C timely
elects salary reduction for employer-provided accident and health
coverage for himself and for accident and health coverage for his
former spouse. C's former spouse is not C's dependent. A former
spouse is not a spouse as defined in section 152.
(ii) The fair market value of the coverage for the former spouse
is $1,000. Employee C has $1,000 includible in gross income for the
accident and health coverage of his former spouse, because the
section 106 exclusion applies only to employer-provided accident and
health coverage for the employee or the employee's spouse or
dependents.
(iii) No payments or reimbursements received under the accident
and health coverage result in gross income to Employee C or to the
former spouse. The result is the same if the $1,000 for coverage of
C's former spouse is paid from C's after-tax income outside the
cafeteria plan.
(i) Prohibited taxable benefits. Any taxable benefit not described
in paragraph (a)(2) of this section and not treated as cash for
purposes of section 125 in paragraph (h) of this section is not
permitted to be included in a cafeteria plan. A plan that offers
taxable benefits other than the taxable benefits described in paragraph
(a)(2) and (h) of this section is not a cafeteria plan.
(j) Coordination with other rules--(1) In general. If a benefit is
excludible from an employee's gross income when provided separately,
the benefit is excludible from gross income when provided through a
cafeteria plan. Thus, a qualified benefit is excludible from gross
income if both the rules under section 125 and the specific rules
providing for the exclusion of the benefit from gross income are
satisfied. For example, if the nondiscrimination rules for specific
qualified benefits (for example, sections 79(d), 105(h), 129(d)(2),
137(c)(2)) are not satisfied, those qualified benefits are includible
in gross income. Thus, if $50,000 in group-term life insurance is
offered through a cafeteria plan, the nondiscrimination rules in
section 79(d) must be satisfied in order to exclude the coverage from
gross income.
(2) Section 125 nondiscrimination rules. Qualified benefits are
includible in the gross income of highly compensated participants or
key employees if the nondiscrimination rules of section 125 are not
satisfied. See Sec. 1.125-7.
(3) Taxable benefits. If a benefit that is includible in gross
income when offered separately is offered through a cafeteria plan, the
benefit continues to be includible in gross income.
(k) Group-term life insurance--(1) In general. In addition to
offering up to $50,000 in group-term life insurance coverage excludible
under section 79(a), a cafeteria plan may offer coverage in excess of
that amount. The cost of coverage in excess of $50,000 in group-term
life insurance coverage provided under a policy or policies carried
directly or indirectly by one or more employers (taking into account
all coverage provided both through a cafeteria plan and outside a
cafeteria plan) is includible in an employee's gross income. Group-term
life insurance combined with permanent benefits, within the meaning of
Sec. 1.79-0, is a prohibited benefit in a cafeteria plan.
(2) Determining cost of insurance includible in employee's gross
income--(i) In general. If the aggregate group-term life insurance
coverage on the life of the employee (under policies carried directly
or indirectly by the employer) exceeds $50,000, all or a portion of the
insurance is provided through a cafeteria plan, and the group-term life
insurance is provided through a plan that meets the nondiscrimination
rules of section 79(d), the amount includible in an employee's gross
income is determined under paragraphs (k)(2)(i)(A) through (C) of this
section. For each employee--
(A) The entire amount of salary reduction and employer flex-credits
through a cafeteria plan for group-term life insurance coverage on the
life of the employee is excludible from the employee's gross income,
regardless of the amount of employer-provided group-term life insurance
on the employee's life (that is, whether or not the coverage provided
to the employee both through the cafeteria plan and outside the
cafeteria plan exceeds $50,000);
(B) The cost of the group-term life insurance in excess of $50,000
of coverage is includible in the employee's gross income. The amount
includible in the employee's income is determined
[[Page 43952]]
using the rules of Sec. 1.79-3 and Table I (Uniform Premiums for
$1,000 of Group-Term Life Insurance Protection). See subparagraph (C)
of this paragraph (k)(2)(i) for determining the amount paid by the
employee for purposes of reducing the Table I amount includible in
income under Sec. 1.79-3.
(C) In determining the amount paid by the employee toward the
purchase of the group-term life insurance for purposes of Sec. 1.79-3,
only an employee's after-tax contributions are treated as an amount
paid by the employee.
(ii) Examples. The rules in this paragraph (k) are illustrated by
the following examples, in which the group-term life insurance coverage
satisfies the nondiscrimination rules in section 79(d), provides no
permanent benefits, is for a 12-month period, is the only group-term
life insurance coverage provided under a policy carried directly or
indirectly by the employer, and applies Table I (Uniform Premiums for
$1,000 of Group-Term Life Insurance Protection) effective July 1, 1999:
Example 1. Excess group-term life insurance coverage provided
through salary reduction in a cafeteria plan. (i) Employer N
provides group-term life insurance coverage to its employees only
through its cafeteria plan. Employer N's cafeteria plan allows
employees to elect salary reduction for group-term life insurance.
Employee B, age 42, elected salary reduction of $200 for $150,000 of
group-term life insurance. None of the group-term life insurance is
paid through after-tax employee contributions.
(ii) B's $200 of salary reduction for group-term life insurance
is excludible from B's gross income under paragraph (k)(2)(i)(A).
(iii) B has a total of $150,000 of group-term life insurance.
The group-term life insurance in excess of the dollar limitation of
section 79 is $100,000 (150,000-50,000).
(iv) The Table I cost is $120 for $100,000 of group-term life
insurance for an individual between ages 40 to 44. The Table I cost
of $120 is reduced by zero (because B paid no portion of the group-
term life insurance with after-tax employee contributions), under
paragraphs (k)(2)(i)(A)-(B) of this section.
(v) The amount includible in B's gross income for the $100,000
of excess group-term life insurance is $120.
Example 2. Excess group-term life insurance coverage provided
through salary reduction in a cafeteria plan where employee
purchases a portion of group-term life insurance coverage with
after-tax contributions. (i) Same facts as Example 1, except that B
elected salary reduction of $100 and makes an after-tax contribution
of $100 toward the purchase of group-term life insurance coverage.
(ii) B's $100 of salary reduction for group-term life insurance
is excludible from B's gross income, under paragraph (k)(2)(i)(A) of
this section.
(iii) B has a total of $150,000 of group-term life insurance.
The group-term life insurance in excess of the dollar limitation of
section 79 is $100,000 (150,000-50,000).
(iv) The Table I cost is $120 for $100,000 of group-term life
insurance for an individual between ages 40 to 44, under
(k)(2)(i)(B). The Table I cost of $120 is reduced by $100 (because B
paid $100 for the group-term life insurance with after-tax employee
contributions), under paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of
this section.
(v) The amount includible in B's gross income for the $100,000
of excess group-term life insurance coverage is $20.
Example 3. Excess group-term life insurance coverage provided
through salary reduction in a cafeteria plan and outside a cafeteria
plan. (i) Same facts as Example 1 except that Employer N also
provides (at no cost to employees) group-term life insurance
coverage equal to each employee's annual salary. Employee B's annual
salary is $150,000. B has $150,000 of group-term life insurance
directly from Employer N, and also $150,000 coverage through
Employer N's cafeteria plan.
(ii) B's $200 of salary reduction for group-term life insurance
is excludible from B's gross income, under paragraph (k)(2)(i)(A) of
this section.
(iii) B has a total of $300,000 of group-term life insurance.
The group-term life insurance in excess of the dollar limitation of
section 79 is $250,000 (300,000-50,000).
(iv) The Table I cost is $300 for $250,000 of group-term life
insurance for an individual between ages 40 to 44. The Table I cost
of $300 is reduced by zero (because B paid no portion of the group-
term life insurance with after-tax employee contributions), under
paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section.
(v) The amount includible in B's gross income for the $250,000
of excess group-term life insurance is $300.
Example 4. Excess group-term life insurance coverage provided
through salary reduction in a cafeteria plan and outside a cafeteria
plan. (i) Same facts as Example 3 except that Employee C's annual
salary is $30,000. C has $30,000 of group-term life insurance
coverage provided directly from Employer N, and elects an additional
$30,000 of coverage for $40 through Employer N's cafeteria plan. C
is 42 years old.
(ii) C's $40 of salary reduction for group-term life insurance
is excludible from C's gross income, under paragraph (k)(2)(i)(A) of
this section.
(iii) C has a total of $60,000 of group-term life insurance. The
group-term life insurance in excess of the dollar limitation of
section 79 is $10,000 (60,000-50,000).
(iv) The Table I cost is $12 for $10,000 of group-term life
insurance for an individual between ages 40 to 44. The Table I cost
of $12 is reduced by zero (because C paid no portion of the group-
term life insurance with after-tax employee contributions), under
paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section.
(v) The amount includible in C's gross income for the $10,000 of
excess group-term life insurance coverage is $12.
(l) COBRA premiums--(1) Paying COBRA premiums through a cafeteria
plan. Under Sec. 1.125-4(c)(3)(iv), COBRA premiums for an employer-
provided group health plan are qualified benefits if:
(i) The premiums are excludible from an employee's income under
section 106; or
(ii) The premiums are for the accident and health plan of the
employer sponsoring the cafeteria plan, even if the fair market value
of the premiums is includible in an employee's gross income. See also
paragraph (e)(2) in Sec. 1.125-5 and Sec. 54.4980B-2, Q & A-8 of this
chapter for COBRA rules for health FSAs.
(2) Example. The following example illustrates the rules of this
paragraph (l):
Example. COBRA premiums. (i) Employer O maintains a cafeteria
plan for full-time employees, offering an election between cash and
employer-provided accident and health insurance and other qualified
benefits. Employees A, B, and C participate in the cafeteria plan.
On July 1, 2009, Employee A has a qualifying event (as defined in
Sec. 54.4980B-4 of this chapter).
(ii) Employee A was a full-time employee and became a part-time
employee and for that reason, is no longer covered by Employer O's
accident and health plan. Under Sec. 1.125-4(f)(3)(ii), Employee A
changes her election to salary reduce to pay her COBRA premiums.
(iii) Employee B previously worked for another employer, quit
and elected COBRA. Employee B begins work for Employer O on July 1,
2009, and becomes eligible to participate in Employer O's cafeteria
plan on July 1, 2009, but will not be eligible to participate in
Employer O's accident and health plan until October 1, 2009.
Employee B elects to salary reduce to pay COBRA premiums for
coverage under the accident and health plan sponsored by B's former
employer.
(iv) Employee C and C's spouse are covered by Employer O's
accident and health plan until July 1, 2009, when C's divorce from
her spouse became final. C continues to be covered by the accident
and health plan. On July 1, 2009, C requests to pay COBRA premiums
for her former spouse (who is not C's dependent (as defined in
section 152)) with after-tax employee contributions.
(v) Salary reduction elections for COBRA premiums for Employees
A and B are qualified benefits for purposes of section 125 and are
excludible from the gross income of Employees A and B. Employer O
allows A and B to salary reduce for these COBRA premiums.
(vi) Employer O allows C to pay for COBRA premiums for C's
former spouse, with after-tax employee contributions because
although accident and health coverage for C's former spouse is
permitted in a cafeteria plan, the premiums are includible in C's
gross income.
(vii) The operation of Employer O's cafeteria plan satisfies the
requirements of this paragraph (l).
(m) Payment or reimbursement of employees' individual accident and
[[Page 43953]]
health insurance premiums--(1) In general. The payment or reimbursement
of employees' substantiated individual health insurance premiums is
excludible from employees' gross income under section 106 and is a
qualified benefit for purposes of section 125.
(2) Example. The following example illustrates the rule of this
paragraph (m):
Example. Payment or reimbursement of premiums. (i) Employer P's
cafeteria plan offers the following benefits for employees who are
covered by an individual health insurance policy. The employee
substantiates the expenses for the premiums for the policy (as
required in paragraph (b)(2) in Sec. 1.125-6) before any payments
or reimbursements to the employee for premiums are made. The
payments or reimbursements are made in the following ways:
(ii) The cafeteria plan reimburses each employee directly for
the amount of the employee's substantiated health insurance premium;
(iii) The cafeteria plan issues the employee a check payable to
the health insurance company for the amount of the employee's health
insurance premium, which the employee is obligated to tender to the
insurance company;
(iv) The cafeteria plan issues a check in the same manner as
(iii), except that the check is payable jointly to the employee and
the insurance company; or
(v) Under these circumstances, the individual health insurance
policies are accident and health plans as defined in Sec. 1.106-1.
This benefit is a qualified benefit under section 125.
(n) Section 105 rules for accident and health plan offered through
a cafeteria plan--(1) General rule. In order for an accident and health
plan to be a qualified benefit that is excludible from gross income if
elected through a cafeteria plan, the cafeteria plan must satisfy
section 125 and the accident and health plan must satisfy section
105(b) and (h).
(2) Section 105(b) requirements in general. Section 105(b) provides
an exclusion from gross income for amounts paid to an employee from an
employer-funded accident and health plan specifically to reimburse the
employee for certain expenses for medical care (as defined in section
213(d)) incurred by the employee or the employee's spouse or dependents
during the period for which the benefit is provided to the employee
(that is, when the employee is covered by the accident and health
plan).
(o) Prohibition against deferred compensation--(1) In general. Any
plan that offers a benefit that defers compensation (except as provided
in this paragraph (o)) is not a cafeteria plan. See section
125(d)(2)(A). A plan that permits employees to carry over unused
elective contributions, after-tax contributions, or plan benefits from
one plan year to another (except as provided in paragraphs (e), (o)(3)
and (4) and (p) of this section) defers compensation. This is the case
regardless of how the contributions or benefits are used by the
employee in the subsequent plan year (for example, whether they are
automatically or electively converted into another taxable or
nontaxable benefit in the subsequent plan year or used to provide
additional benefits of the same type). Similarly, a cafeteria plan also
defers compensation if the plan permits employees to use contributions
for one plan year to purchase a benefit that will be provided in a
subsequent plan year (for example, life, health or disability if these
benefits have a savings or investment feature, such as whole life
insurance). See also Q & A-5 in Sec. 1.125-3, prohibiting deferring
compensation from one cafeteria plan year to a subsequent cafeteria
plan year. See paragraph (e) of this section for grace period rules. A
plan does not defer compensation merely because it allocates experience
gains (or forfeitures) among participants in compliance with paragraph
(o) in Sec. 1.125-5.
(2) Effect if a plan includes a benefit that defers the receipt of
compensation or a plan operates to defer compensation. If a plan
violates paragraph (o)(1) of this section, the availability of an
election between taxable and nontaxable benefits under such a plan
results in gross income to the employees.
(3) Cash or deferred arrangements that may be offered in a
cafeteria plan. (i) In general. A cafeteria plan may offer the benefits
set forth in this paragraph (o)(3), even though these benefits defer
compensation.
(ii) Elective contributions to a section 401(k) plan. A cafeteria
plan may permit a covered employee to elect to have the employer, on
behalf of the employee, pay amounts as contributions to a trust that is
part of a profit-sharing or stock bonus plan or rural cooperative plan
(within the meaning of section 401(k)(7)), which includes a qualified
cash or deferred arrangement (as defined in section 401(k)(2)). In
addition, after-tax employee contributions under a qualified plan
subject to section 401(m) are permitted through a cafeteria plan. The
right to make such contributions does not cause a plan to fail to be a
cafeteria plan merely because, under the qualified plan, employer
matching contributions (as defined in section 401(m)(4)(A)) are made
with respect to elective or after-tax employee contributions.
(iii) Additional permitted deferred compensation arrangements. A
plan maintained by an educational organization described in section
170(b)(1)(A)(ii) to the extent of amounts which a covered employee may
elect to have the employer pay as contributions for post-retirement
group life insurance is permitted through a cafeteria plan, if--
(A) All contributions for such insurance must be made before
retirement; and
(B) Such life insurance does not have a cash surrender value at any
time.
(iv) Contributions to HSAs. Contributions to covered employees'
HSAs as defined in section 223 (but not contributions to Archer MSAs).
(4) Paid time off--(i) In general. A cafeteria plan is permitted to
include elective paid time off (that is, vacation days, sick days or
personal days) as a permitted taxable benefit through the plan by
permitting employees to receive more paid time off than the employer
otherwise provides to the employees on a nonelective basis, but only if
the inclusion of elective paid time off through the plan does not
operate to permit the deferral of compensation. In addition, a plan
that only offers the choice of cash or paid time off is not a cafeteria
plan and is not subject to the rules of section 125. In order to avoid
deferral of compensation, the cafeteria plan must preclude any employee
from using the paid time off or receiving cash, in a subsequent plan
year, for any portion of such paid time off remaining unused as of the
end of the plan year. (See paragraph (o)(4)(iii) of this section for
the deadline to cash out unused elective paid time off.) For example, a
plan that offers employees the opportunity to purchase paid time off
(or to receive cash or other benefits through the plan in lieu of paid
time off) is not a cafeteria plan if employees who purchase the paid
time off for a plan year are allowed to use any unused paid time off in
a subsequent plan year. This is the case even though the plan does not
permit the employee to convert, in any subsequent plan year, the unused
paid time off into any other benefit.
(ii) Ordering of elective and nonelective paid time off. In
determining whether a plan providing paid time off operates to permit
the deferral of compensation, a cafeteria plan must provide that
employees are deemed to use paid time off in the following order:
(A) Nonelective paid time off. Nonelective paid time off (that is,
paid time off with respect to which the employee has no election) is
used first;
[[Page 43954]]
(B) Elective paid time off. Elective paid time off is used after
all nonelective paid time off is used.
(iii) Cashing out or forfeiture of unused elective paid time off,
in general. The cafeteria plan must provide that all unused elective
paid time off (determined as of the last day of the plan year) must
either be paid in cash (within the time specified in this paragraph
(o)(4)) or be forfeited. This provision must apply uniformly to all
participants in the cafeteria plan.
(A) Cash out of unused elective paid time off. A plan does not
operate to permit the deferral of compensation merely because the plan
provides that an employee who has not used all elective paid time off
for a plan year receives in cash the value of such unused paid time
off. The employee must receive the cash on or before the last day of
the cafeteria plan's plan year to which the elective contributions used
to purchase the unused elective paid time off relate.
(B) Forfeiture of unused elective paid time off. If the cafeteria
plan provides for forfeiture of unused elective paid time off, the
forfeiture must be effective on the last day of the plan year to which
the elective contributions relate.
(iv) No grace period for paid time off. The grace period described
in paragraph (e) of this section does not apply to paid time off.
(v) Examples. The following examples illustrate the rules of this
paragraph (o)(4):
Example 1. Plan cashes out unused elective paid time off on or
before the last day of the plan year. (i) Employer Q provides
employees with two weeks of paid time off for each calendar year.
Employer Q's human resources policy (that is, outside the cafeteria
plan), permits employees to carry over one nonelective week of paid
time off to the next year. Employer Q maintains a calendar year
cafeteria plan that permits the employee to purchase, with elective
contributions, an additional week of paid time off.
(ii) For the 2009 plan year, Employee A (with a calendar tax
year), timely elects to purchase one additional week of paid time
off. During 2009, Employee A uses only two weeks of paid time off.
Employee A is deemed to have used two weeks of nonelective paid time
off and zero weeks of elective paid time off.
(iii) Pursuant to the cafeteria plan, the plan pays Employee A
the value of the unused elective paid time off week in cash on
December 31, 2009. Employer Q includes this amount on the 2009 Form
W-2 for Employee A. This amount is included in Employee A's gross
income in 2009. The cafeteria plan's terms and operations do not
violate the prohibition against deferring compensation.
Example 2. Unused nonelective paid time off carried over to next
plan year. (i) Same facts as Example 1, except that Employee A uses
only one week of paid time off during the year. Pursuant to the
cafeteria plan, Employee A is deemed to have used one nonelective
week, and having retained one nonelective week and one elective week
of paid time off. Employee A receives in cash the value of the
unused elective paid time off on December 31, 2009. Employer Q
includes this amount on the 2009 Form W-2 for Employee A. Employee A
must report this amount as gross income in 2009.
(ii) Pursuant to Employer Q's human resources policy, Employee A
is permitted to carry over the one nonelective week of paid time off
to the next year. Nonelective paid time off is not part of the
cafeteria plan (that is, neither Employer Q nor the cafeteria plan
permit employees to exchange nonelective paid time off for other
benefits).
(iii) The cafeteria plan's terms and operations do not violate
the prohibition against deferring compensation.
Example 3. Forfeiture of unused elective paid time off. Same
facts as Example 2, except that pursuant to the cafeteria plan,
Employee A forfeits the remaining one week of elective paid time
off. The cafeteria plan's terms and operations do not violate the
prohibition against deferring compensation.
Example 4. Unused elective paid time off carried over to next
plan year. Same facts as Example 1, except that Employee A uses only
two weeks of paid time off during the 2009 plan year, and, under the
terms of the cafeteria plan, Employee A is treated as having used
the two nonelective weeks and as having retained the one elective
week. The one remaining week (that is, the elective week) is carried
over to the next plan year (or the value thereof used for any other
purpose in the next plan year). The plan operates to permit
deferring compensation and is not a cafeteria plan.
Example 5. Paid time off exchanged for accident and health
insurance premiums. Employer R provides employees with four weeks of
paid time off for a year. Employer R's calendar year cafeteria plan
permits employees to exchange up to one week of paid time off to pay
the employee's share of accident and health insurance premiums. For
the 2009 plan year, Employee B (with a calendar tax year), timely
elects to exchange one week of paid time off (valued at $769) to pay
accident and health insurance premiums for 2009. The $769 is
excludible from Employee B's gross income under section 106. The
cafeteria plan's terms and operations do not violate the prohibition
against deferring compensation.
(p) Benefits relating to more than one year--(1) Benefits in an
accident and health insurance policy relating to more than one year.
Consistent with section 125(d), an accident and health insurance policy
may include certain benefits, as set forth in this paragraph (p)(1),
without violating the prohibition against deferred compensation.
(i) Permitted benefits. The following features or benefits of
insurance policies do not defer compensation--
(A) Credit toward the deductible for unreimbursed covered expenses
incurred in prior periods;
(B) Reasonable lifetime maximum limit on benefits;
(C) Level premiums;
(D) Premium waiver during disability;
(E) Guaranteed policy renewability of coverage, without further
evidence of insurability (but not guaranty of the amount of premium
upon renewal);
(F) Coverage for a specified accidental injury;
(G) Coverage for a specified disease or illness, including payments
at initial diagnosis of the specified disease or illness, and
progressive payments of a set amount per month following the initial
diagnosis (sometimes referred to as progressive diagnosis payments);
and
(H) Payment of a fixed amount per day (or other period) of
hospitalization.
(ii) Requirements of permitted benefits. All benefits described in
paragraph (p)(1)(i) of this section must in addition satisfy all of the
following requirements--
(A) No part of any benefit is used in one plan year to purchase a
benefit in a subsequent plan year;
(B) The policies remain in force only so long as premiums are
timely paid on a current basis, and, irrespective of the amount of
premiums paid in prior plan years, if the current premiums are not
paid, all coverage for new diseases or illnesses lapses. See paragraph
(p)(1)(i)(D), allowing premium waiver during disability;
(C) There is no investment fund or cash value to rely upon for
payment of premiums; and
(D) No part of any premium is held in a separate account for any
participant or beneficiary, or otherwise segregated from the assets of
the insurance company.
(2) Benefits under a long-term disability policy relating to more
than one year. A long-term disability policy paying disability benefits
over more than one year does not violate the prohibition against
deferring compensation.
(3) Reasonable premium rebates or policy dividends. Reasonable
premium rebates or policy dividends paid with respect to benefits
provided through a cafeteria plan do not constitute impermissible
deferred compensation if such rebates or dividends are paid before the
close of the 12-month period immediately following the cafeteria plan
year to which such rebates and dividends relate.
(4) Mandatory two-year election for vision or dental insurance.
When a cafeteria plan offers vision or dental insurance that requires a
mandatory two-year coverage period, but not longer (sometimes referred
to as a ``two-year lock-in''), the mandatory two-year
[[Page 43955]]
coverage period does not result in deferred compensation in violation
of section 125(d)(2), provided both of the following requirements are
satisfied--
(i) The premiums for each plan year are paid no less frequently
than annually; and
(ii) In no event does a cafeteria plan use salary reduction or
flex-credits relating to the first year of a two-year election to apply
to vision or dental insurance for the second year of the two-year
election.
(5) Using salary reduction amounts from one plan year to pay
accident and health insurance premiums for the first month of the
immediately following plan year.
(i) In general. Salary reduction amounts from the last month of one
plan year of a cafeteria plan may be applied to pay accident and health
insurance premiums for insurance during the first month of the
immediately following plan year, if done on a uniform and consistent
basis with respect to all participants (based on the usual payroll
interval for each group of participants).
(ii) Example. The following example illustrates the rules in this
paragraph (p)(5):
Example. Salary reduction payments in December of calendar plan
year to pay accident and health insurance premiums for January.
Employer S maintains a calendar year cafeteria plan. The cafeteria
plan offers employees a salary reduction election for accident and
health insurance. The plan provides that employees' salary reduction
amounts for the last pay period in December are applied to pay
accident and health insurance premiums for the immediately following
January. All employees are paid bi-weekly. For the plan year ending
December 31, 2009, Employee C elects salary reduction of $3,250 for
accident and health coverage. For the last pay period in December
2009, $125 (3,250/26) is applied to the accident and health
insurance premium for January 2010. This plan provision does not
violate the prohibition against deferring compensation.
(q) Nonqualified benefits--(1) In general. The following benefits
are nonqualified benefits that are not permitted to be offered in a
cafeteria plan--
(i) Scholarships described in section 117;
(ii) Employer-provided meals and lodging described in section 119;
(iii) Educational assistance described in section 127;
(iv) Fringe benefits described in section 132;
(v) Long-term care insurance, or any product which is advertised,
marketed or offered as long-term care insurance;
(vi) Long-term care services (but see paragraph (q)(3) of this
section);
(vii) Group-term life insurance on the life of any individual other
than an employee (whether includible or excludible from the employee's
gross income);
(viii) 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 a coverage period is
carried forward to increase the maximum reimbursement amount in
subsequent coverage periods;
(ix) Contributions to Archer MSAs (section 220); and
(x) Elective deferrals to a section 403(b) plan.
(2) Nonqualified benefits not permitted in a cafeteria plan. The
benefits described in this paragraph (q) are not qualified benefits or
taxable benefits or cash for purposes of section 125 and thus may not
be offered in a cafeteria plan regardless of whether any such benefit
is purchased with after-tax employee contributions or on any other
basis. A plan that offers a nonqualified benefit is not a cafeteria
plan. Employees' elections between taxable and nontaxable benefits
through such plan result in gross income to the participants for any
benefit elected. See section 125(f). See paragraph (q)(3) of this
section for special rule on long-term care insurance purchased through
an HSA.
(3) Long-term care insurance or services purchased through an HSA.
Although long-term care insurance is not a qualified benefit and may
not be offered in a cafeteria plan, a cafeteria plan is permitted to
offer an HSA as a qualified benefit, and funds from the HSA may be used
to pay eligible long-term care premiums on a qualified long-term care
insurance contract or for qualified long-term care services.
(r) Employer contributions to a cafeteria plan--(1) Salary
reduction-in general. The term employer contributions means amounts
that are not currently available (after taking section 125 into
account) to the employee but are specified in the cafeteria plan as
amounts that an employee may use for the purpose of electing benefits
through the plan. A plan may provide that employer contributions may be
made, in whole or in part, pursuant to employees' elections to reduce
their compensation or to forgo increases in compensation and to have
such amounts contributed, as employer contributions, by the employer on
their behalf. See also Sec. 1.125-5 (flexible spending arrangements).
Also, a cafeteria plan is permitted to require employees to elect to
pay the employees' share of any qualified benefit through salary
reduction and not with after-tax employee contributions. A cafeteria
plan is also permitted to pay reasonable cafeteria plan administrative
fees through salary reduction amounts, and these salary reduction
amounts are excludible from an employee's gross income.
(2) Salary reduction as employer contribution. Salary reduction
contributions are employer contributions. An employee's salary
reduction election is an election to receive a contribution by the
employer in lieu of salary or other compensation that is not currently
available to the employee as of the effective date of the election and
that does not subsequently become currently available to the employee.
(3) Employer flex-credits. A cafeteria plan may also provide that
the employer contributions will or may be made on behalf of employees
equal to (or up to) specified amounts (or specified percentages of
compensation) and that such nonelective contributions are available to
employees for the election of benefits through the plan.
(4) Elective contributions to a section 401(k) plan. See Sec.
1.401(k)-1 for general rules relating to contributions to section
401(k) plans.
(s) Effective/applicability date. It is proposed that these
regulations apply on and after plan years beginning on or after January
1, 2009, except that the rule in paragraph (k)(2)(i)(B) of this section
is effective as of the date the proposed regulations are published in
the Federal Register.
Sec. 1.125-2 Cafeteria plans; elections.
(a) Rules relating to making and revoking elections--(1) Elections
in general. A plan is not a cafeteria plan unless the plan provides in
writing that employees are permitted to make elections among the
permitted taxable benefits and qualified benefits offered through the
plan for the plan year (and grace period, if applicable). All elections
must be irrevocable by the date described in paragraph (a)(2) of this
section except as provided in paragraph (a)(4) of this section. An
election is not irrevocable if, after the earlier of the dates
specified in paragraph (a)(2) of this section, employees have the right
to revoke their elections of qualified benefits and instead receive the
taxable benefits for such period, without regard to whether the
employees actually revoke their elections.
(2) Timing of elections. In order for employees to exclude
qualified benefits from employees' gross income, benefit
[[Page 43956]]
elections in a cafeteria plan must be made before the earlier of--
(i) The date when taxable benefits are currently available; or
(ii) The first day of the plan year (or other coverage period).
(3) Benefit currently available to an employee-in general. Cash or
another taxable benefit is currently available to the employee if it
has been paid to the employee or if the employee is able currently to
receive the cash or other taxable benefit at the employee's discretion.
However, cash or another taxable benefit is not currently available to
an employee if there is a significant limitation or restriction on the
employee's right to receive the benefit currently. Similarly, a benefit
is not currently available as of a date if the employee may under no
circumstances receive the benefit before a particular time in the
future. The determination of whether a benefit is currently available
to an employee does not depend on whether it has been constructively
received by the employee for purposes of section 451.
(4) Exceptions to rule on making and revoking elections. If a
cafeteria plan incorporates the change in status rules in Sec. 1.125-
4, to the extent provided in those rules, an employee who experiences a
change in status (as defined in Sec. 1.125-4) is permitted to revoke
an existing election and to make a new election with respect to the
remaining portion of the period of coverage, but only with respect to
cash or other taxable benefits that are not yet currently available.
See paragraph (c)(1) of this section for a special rule for changing
elections prospectively for HSA contributions and paragraph (r)(4) in
Sec. 1.125-1 for section 401(k) elections. Also, only an employee of
the employer sponsoring a cafeteria plan is allowed to make, revoke or
change elections in the employer's cafeteria plan. The employee's
spouse, dependent or any other individual other than the employee may
not make, revoke or change elections under the plan.
(5) Elections not required on written paper documents. A cafeteria
plan does not fail to meet the requirements of section 125 merely
because it permits employees to use electronic media for such
transactions. The safe harbor in Sec. 1.401(a)-21 applies to
electronic elections, revocations and changes in elections under
section 125.
(6) Examples. The following examples illustrate the rules in this
paragraph (a):
Example 1. Election not revocable during plan year. Employer A's
cafeteria plan offers each employee the opportunity to elect, for a
plan year, between $5,000 cash for the plan year and a dependent
care assistance program of up to $5,000 of dependent care expenses
incurred by the employee during the plan year. The cafeteria plan
requires employees to elect between these benefits before the
beginning of the plan year. After the year has commenced, employees
are prohibited from revoking their elections. The cafeteria plan
allows revocation of elections based on changes in status (as
described in Sec. 1.125-4). Employees who elected the dependent
care assistance program do not include the $5,000 cash in gross
income. The cafeteria plan satisfies the requirements in this
paragraph (a).
Example 2. Election revocable during plan year. Same facts as
Example 1 except that Employer A's cafeteria plan allows employees
to revoke their elections for dependent care assistance at any time
during the plan year and receive the unused amount of dependent care
assistance as cash. The cafeteria plan fails to satisfy the
requirements in this paragraph (a), and is not a cafeteria plan. All
employees are treated as having received the $5,000 in cash even if
they do not revoke their elections. The same result occurs even
though the cash is not payable until the end of the plan year.
(b) Automatic elections--(1) In general. For new employees or
current employees who fail to timely elect between permitted taxable
benefits and qualified benefits, a cafeteria plan is permitted, but is
not required, to provide default elections for one or more qualified
benefits (for example, an election made for any prior year is deemed to
be continued for every succeeding plan year, unless changed).
(2) Example. The following example illustrates the rules in this
paragraph (b):
Example. Automatic elections for accident and health insurance.
(i) Employer B maintains a calendar year cafeteria plan. The
cafeteria plan offers accident and health insurance with an option
for employee-only or family coverage. All employees are eligible to
participate in the cafeteria plan immediately upon hire.
(ii) The cafeteria plan provides for an automatic enrollment
process: Each new employee and each current employee is
automatically enrolled in employee-only coverage under the accident
and health insurance plan, and the employee's salary is reduced to
pay the employee's share of the accident and health insurance
premium, unless the employee affirmatively elects cash.
Alternatively, if the employee has a spouse or child, the employee
can elect family coverage.
(iii) When an employee is hired, the employee receives a notice
explaining the automatic enrollment process and the employee's right
to decline coverage and have no salary reduction. The notice
includes the salary reduction amounts for employee-only coverage and
family coverage, procedures for exercising the right to decline
coverage, information on the time by which an election must be made,
and the period for which an election is effective. The notice is
also given to each current employee before the beginning of each
subsequent plan year, except that the notice for a current employee
includes a description of the employee's existing coverage, if any.
(iv) For a new employee, an election to receive cash or to have
family coverage rather than employee-only coverage is effective if
made when the employee is hired. For a current employee, an election
is effective if made prior to the start of each calendar year or
under any other circumstances permitted under Sec. 1.125-4. An
election made for any prior year is deemed to be continued for every
succeeding plan year, unless changed.
(v) Contributions used to purchase accident and health insurance
through a cafeteria plan are not includible in the gross income of
the employee solely because the plan provides for automatic
enrollment as a default election whereby the employee's salary is
reduced each year to pay for a portion of the accident and health
insurance through the plan (unless the employee affirmatively elects
cash).
(c) Election rules for salary reduction contributions to HSAs--(1)
Prospective elections and changes in salary reduction elections
allowed. Contributions may be made to an HSA through a cafeteria plan.
A cafeteria plan offering HSA contributions through salary reduction
may permit employees to make prospective salary reduction elections or
change or revoke salary reduction elections for HSA contributions (for
example, to increase or decrease salary reduction elections for HSA
contributions) at any time during the plan year, effective before
salary becomes currently available. If a cafeteria plan offers HSA
contributions as a qualified benefit, the plan must--
(i) Specifically describe the HSA contribution benefit;
(ii) Allow a participant to prospectively change his or her salary
reduction election for HSA contributions on a monthly basis (or more
frequently); and
(iii) Allow a participant who becomes ineligible to make HSA
contributions to prospectively revoke his or her salary reduction
election for HSA contributions.
(2) Example. The following example illustrates the rules in this
paragraph (c):
Example. Prospective HSA salary reduction elections. (i) A
cafeteria plan with a calendar plan year allows employees to make
salary reduction elections for HSA contributions through the plan.
The cafeteria plan permits employees to prospectively make, change
or revoke salary contribution elections for HSA contributions,
limited to one election, change or revocation per month.
(ii) Employee M participates in the cafeteria plan. Before
salary becomes currently available to M, M makes the following
elections. On January 2, 2009, M elects to contribute $100 for each
pay period to an HSA, effective January 3, 2009. On
[[Page 43957]]
March 15, 2009, M elects to reduce the HSA contribution to $35 per
pay period, effective April 1, 2009. On May 1, 2009, M elects to
discontinue all HSA contributions, effective May 15, 2009. The
cafeteria plan implements all of Employee M's elections,
(iii) The cafeteria plan's operation is consistent with the
section 125 election, change and revocation rules for HSA
contributions.
(d) Optional election for new employees. A cafeteria plan may
provide new employees 30 days after their hire date to make elections
between cash and qualified benefits. The election is effective as of
the employee's hire date. However, salary reduction amounts used to pay
for such an election must be from compensation not yet currently
available on the date of the election. The written cafeteria plan must
provide that any employee who terminates employment and is rehired
within 30 days after terminating employment (or who returns to
employment following an unpaid leave of absence of less than 30 days)
is not a new employee eligible for the election in this paragraph (d).
(e) Effective/applicability date. It is proposed that these
regulations apply on and after plan years beginning on or after January
1, 2009.
Par. 3. Sections 1.125-5, 1.125-6 and 1.125-7 are added to read as
follows:
Sec. 1.125-5 Flexible spending arrangements.
(a) Definition of flexible spending arrangement--(1) In general. An
FSA generally is a benefit program that provides employees with
coverage which reimburses specified, incurred expenses (subject to
reimbursement maximums and any other reasonable conditions). An expense
for qualified benefits must not be reimbursed from the FSA unless it is
incurred during a period of coverage. See paragraph (e) of this
section. After an expense for a qualified benefit has been incurred,
the expense must first be substantiated before the expense is
reimbursed. See paragraphs (a) through (f) in Sec. 1.125-6.
(2) Maximum amount of reimbursement. The maximum amount of
reimbursement that is reasonably available to an employee for a period
of coverage must not be substantially in excess of the total salary
reduction and employer flex-credit for such participant's coverage. A
maximum amount of reimbursement is not substantially in excess of the
total salary reduction and employer flex-credit if such maximum amount
is less than 500 percent of the combined salary reduction and employer
flex-credit. A single FSA may provide participants with different
levels of coverage and maximum amounts of reimbursement. See paragraph
(r) in Sec. 1.125-1 and paragraphs (b) and (d) in this section for the
definition of salary reduction, employer flex-credit, and uniform
coverage rule.
(b) Flex-credits allowed--(1) In general. An FSA in a cafeteria
plan must include an election between cash or taxable benefits
(including salary reduction) and one or more qualified benefits, and
may include, in addition, ``employer flex-credits.'' For this purpose,
flex-credits are non-elective employer contributions that the employer
makes for every employee eligible to participate in the employer's
cafeteria plan, to be used at the employee's election only for one or
more qualified benefits (but not as cash or a taxable benefit). See
Sec. 1.125-1 for definitions of qualified benefits, cash and taxable
benefits.
(2) Example. The following example illustrates the rules in this
paragraph (b):
Example. Flex-credit. Contribution to health FSA for employees
electing employer-provided accident and health plan. Employer A
maintains a cafeteria plan offering employees an election between
cash or taxable benefits and premiums for employer-provided accident
and health insurance or coverage through an HMO. The plan also
provides an employer contribution of $200 to the health FSA of every
employee who elects accident and health insurance or HMO coverage.
In addition, these employees may elect to reduce their salary to
make additional contributions to their health FSAs. The benefits
offered in this cafeteria plan are consistent with the requirements
of section 125 and this paragraph (b).
(c) Use-or-lose rule--(1) In general. An FSA may not defer
compensation. No contribution or benefit from an FSA may be carried
over to any subsequent plan year or period of coverage. See paragraph
(k)(3) in this section for specific exceptions. Unused benefits or
contributions remaining at the end of the plan year (or at the end of a
grace period, if applicable) are forfeited.
(2) Example. The following example illustrates the rules in this
paragraph (c):
Example. Use-or-lose rule. (i) Employer B maintains a calendar
year cafeteria plan, offering an election between cash and a health
FSA. The cafeteria plan has no grace period.
(ii) Employee A plans to have eye surgery in 2009. For the 2009
plan year, Employee A timely elects salary reduction of $3,000 for a
health FSA. During the 2009 plan year, Employee A learns that she
cannot have eye surgery performed, but incurs other section 213(d)
medical expenses totaling $1,200. As of December 31, 2009, she has
$1,800 of unused benefits and contributions in the health FSA.
Consistent with the rules in this paragraph (c), she forfeits
$1,800.
(d) Uniform coverage rules applicable to health FSAs--(1) Uniform
coverage throughout coverage period--in general. The maximum amount of
reimbursement from a health FSA must be available at all times during
the period of coverage (properly reduced as of any particular time for
prior reimbursements for the same period of coverage). Thus, the
maximum amount of reimbursement at any particular time during the
period of coverage cannot relate to the amount that has been
contributed to the FSA at any particular time prior to the end of the
plan year. Similarly, the payment schedule for the required amount for
coverage under a health FSA may not be based on the rate or amount of
covered claims incurred during the coverage period. Employees' salary
reduction payments must not be accelerated based on employees' incurred
claims and reimbursements.
(2) Reimbursement available at all times. Reimbursement is deemed
to be available at all times if it is paid at least monthly or when the
total amount of the claims to be submitted is at least a specified,
reasonable minimum amount (for example, $50).
(3) Terminated participants. When an employee ceases to be a
participant, the cafeteria plan must pay the former participant any
amount the former participant previously paid for coverage or benefits
to the extent the previously paid amount relates to the period from the
date the employee ceases to be a participant through the end of that
plan year. See paragraph (e)(2) in this section for COBRA elections for
health FSAs.
(4) Example. The following example illustrates the rules in this
paragraph (d):
Example. Uniform coverage. (i) Employer C maintains a calendar
year cafeteria plan, offering an election between cash and a health
FSA. The cafeteria plan prohibits accelerating employees' salary
reduction payments based on employees' incurred claims and
reimbursements.
(ii) For the 2009 plan year, Employee N timely elects salary
reduction of $3,000 for a health FSA. Employee N pays the $3,000
salary reduction amount through salary reduction of $250 per month
throughout the coverage period. Employee N is eligible to receive
the maximum amount of reimbursement of $3,000 at all times
throughout the coverage period (reduced by prior reimbursements).
(iii) N incurs $2,500 of section 213(d) medical expenses in
January, 2009. The full $2,500 is reimbursed although Employee N has
made only one salary reduction payment of $250. N incurs $500 in
medical expenses in February, 2009. The remaining $500 of the $3,000
is reimbursed. After Employee N submits a claim for reimbursement
and substantiates the medical expenses, the cafeteria plan
reimburses N for the $2,500
[[Page 43958]]
and $500 medical expenses. Employer C's cafeteria plan satisfies the
uniform coverage rule.
(5) No uniform coverage rule for FSAs for dependent care assistance
or adoption assistance. The uniform coverage rule applies only to
health FSAs and does not apply to FSAs for dependent care assistance or
adoption assistance. See paragraphs (i) and (j) of this section for the
rules for FSAs for dependent care assistance and adoption assistance.
(e) Required period of coverage for a health FSA, dependent care
FSA and adoption assistance FSA--(1) Twelve-month period of coverage--
in general. An FSA's period of coverage must be 12 months. However, in
the case of a short plan year, the period of coverage is the entire
short plan year. See paragraph (d) in Sec. 1.125-1 for rules on plan
years and changing plan years.
(2) COBRA elections for health FSAs. For the application of the
health care continuation rules of section 4980B of the Code to health
FSAs, see Q & A-2 in Sec. 54.4980B-2 of this chapter.
(3) Separate period of coverage permitted for each qualified
benefit offered through FSA. Dependent care assistance, adoption
assistance, and a health FSA are each permitted to have a separate
period of coverage, which may be different from the plan year of the
cafeteria plan.
(f) Coverage on a month-by-month or expense-by-expense basis
prohibited. In order for reimbursements from an accident and health
plan to qualify for the section 105(b) exclusion, an employer-funded
accident and health plan offered through a cafeteria plan may not
operate in a manner that enables employees to purchase the accident and
health plan coverage only for periods when employees expect to incur
medical care expenses. Thus, for example, if a cafeteria plan permits
employees to receive accident and health plan coverage on a month-by-
month or an expense-by-expense basis, reimbursements from the accident
and health plan fail to qualify for the section 105(b) exclusion. If,
however, the period of coverage under an accident and health plan
offered through a cafeteria plan is twelve months and the cafeteria
plan does not permit an employee to elect specific amounts of coverage,
reimbursement, or salary reduction for less than twelve months, the
cafeteria plan does not operate to enable participants to purchase
coverage only for periods during which medical care will be incurred.
See Sec. 1.125-4 and paragraph (a) in Sec. 1.125-2 regarding the
revocation of elections during a period of coverage on account of
changes in family status.
(g) FSA administrative practices--(1) Limiting health FSA
enrollment to employees who participate in the employer's accident and
health plan. At the employer's option, a cafeteria plan is permitted to
provide that only those employees who participate in one or more
specified employer-provided accident and health plans may participate
in a health FSA. See Sec. 1.125-7 for nondiscrimination rules.
(2) Interval for employees' salary reduction contributions. The
cafeteria plan is permitted to specify any interval for employees'
salary reduction contributions. The interval specified in the plan must
be uniform for all participants.
(h) Qualified benefits permitted to be offered through an FSA.
Dependent care assistance (section 129), adoption assistance (section
137) and a medical reimbursement arrangement (section 105(b)) are
permitted to be offered through an FSA in a cafeteria plan.
(i) Section 129 rules for dependent care assistance program offered
through a cafeteria plan--(1) General rule. In order for dependent care
assistance to be a qualified benefit that is excludible from gross
income if elected through a cafeteria plan, the cafeteria plan must
satisfy section 125 and the dependent care assistance must satisfy
section 129.
(2) Dependent care assistance in general. Section 129(a) provides
an employee with an exclusion from gross income both for an employer-
funded dependent care assistance program and for amounts paid or
incurred by the employer for dependent care assistance provided to the
employee, if the amounts are paid or incurred through a dependent care
assistance program. See paragraph (a)(4) in Sec. 1.125-6 on when
dependent care expenses are incurred.
(3) Reimbursement exclusively for dependent care assistance. A
dependent care assistance program may not provide reimbursements other
than for dependent care expenses; in particular, if an employee has
dependent care expenses less than the amount specified by salary
reduction, the plan may not provide other taxable or nontaxable
benefits for any portion of the specified amount not used for the
reimbursement of dependent care expenses. Thus, if an employee has
elected coverage under the dependent care assistance program and the
period of coverage has commenced, the employee must not have the right
to receive amounts from the program other than as reimbursements for
dependent care expenses. This is the case regardless of whether
coverage under the program is purchased with contributions made at the
employer's discretion, at the employee's discretion, or pursuant to a
collective bargaining agreement. Arrangements formally outside of the
cafeteria plan providing for the adjustment of an employee's
compensation or an employee's receipt of any other benefits on the
basis of the assistance or reimbursements received by the employee are
considered in determining whether a dependent care benefit is a
dependent care assistance program under section 129.
(j) Section 137 rules for adoption assistance program offered
through a cafeteria plan--(1) General rule. In order for adoption
assistance to be a qualified benefit that is excludible from gross
income if elected through a cafeteria plan, the cafeteria plan must
satisfy section 125 and the adoption assistance must satisfy section
137.
(2) Adoption assistance in general. Section 137(a) provides an
employee with an exclusion from gross income for amounts paid or
expenses incurred by the employer for qualified adoption expenses in
connection with an employee's adoption of a child, if the amounts are
paid or incurred through an adoption assistance program. Certain limits
on amount of expenses and employee's income apply.
(3) Reimbursement exclusively for adoption assistance. Rules and
requirements similar to the rules and requirements in paragraph (i)(3)
of this section for dependent care assistance apply to adoption
assistance.
(k) FSAs and the rules governing the tax-favored treatment of
employer-provided health benefits--(1) Medical expenses. Health plans
that are flexible spending arrangements, as defined in paragraph (a)(1)
of this section, must conform to the generally applicable rules under
sections 105 and 106 in order for the coverage and reimbursements under
such plans to qualify for tax-favored treatment under such sections.
Thus, health FSAs must qualify as accident and health plans. See
paragraph (n) in Sec. 1.125-1. A health FSA is only permitted to
reimburse medical expenses as defined in section 213(d). Thus, for
example, a health FSA is not permitted to reimburse dependent care
expenses.
(2) Limiting payment or reimbursement to certain section 213(d)
medical expenses. A health FSA is permitted to limit payment or
reimbursement to only certain section 213(d) medical expenses (except
health insurance, long-term care services or insurance). See paragraph
(q) in Sec. 1.125-1. For example, a health FSA in a cafeteria plan is
permitted to provide in
[[Page 43959]]
the written plan that the plan reimburses all section 213(d) medical
expenses allowed to be paid or reimbursed under a cafeteria plan except
over-the-counter drugs.
(3) Application of prohibition against deferred compensation to
medical expenses--(i) Certain advance payments for orthodontia
permitted. A cafeteria plan is permitted, but is not required to,
reimburse employees for orthodontia services before the services are
provided but only to the extent that the employee has actually made the
payments in advance of the orthodontia services in order to receive the
services. These orthodontia services are deemed to be incurred when the
employee makes the advance payment. Reimbursing advance payments does
not violate the prohibition against deferring compensation.
(ii) Example. The following example illustrates the rules in
paragraph (k)(3):
Example. Advance payment to orthodontist. Employer D sponsors a
calendar year cafeteria plan which offers a health FSA. Employee K
elects to salary reduce $3,000 for a health FSA for the 2009 plan
year. Employee K's dependent requires orthodontic treatment. K's
accident and health insurance does not cover orthodontia. The
orthodontist, following the normal practice, charges $3,000, all due
in 2009, for treatment, to begin in 2009 and end in 2010. K pays the
$3,000 in 2009. In 2009, Employer D's cafeteria plan may reimburse
$3,000 to K, without violating the prohibition against deferring
compensation in section 125(d)(2).
(iii) Reimbursements for durable medical equipment. A health FSA in
a cafeteria plan that reimburses employees for equipment (described in
section 213(d)) with a useful life extending beyond the period of
coverage during which the expense is incurred does not provide deferred
compensation. For example, a health FSA is permitted to reimburse the
cost of a wheelchair for an employee.
(4) No reimbursement of premiums for accident and health insurance
or long-term care insurance or services. A health FSA is not permitted
to treat employees' premium payments for other health coverage as
reimbursable expenses. Thus, for example, a health FSA is not permitted
to reimburse employees for payments for other health plan coverage,
including premiums for COBRA coverage, accidental death and
dismemberment insurance, long-term disability or short-term disability
insurance or for health coverage under a plan maintained by the
employer of the employee or the employer of the employee's spouse or
dependent. Also, a health FSA is not permitted to reimburse expenses
for long-term care insurance premiums or for long-term care services
for the employee or employee's spouse or dependent. See paragraph (q)
in Sec. 1.125-1 for nonqualified benefits
(l) Section 105(h) requirements. Section 105(h) applies to health
FSAs. Section 105(h) provides that the exclusion provided by section
105(b) is not available with respect to certain amounts received by a
highly compensated individual (as defined in section 105(h)(5)) from a
discriminatory self-insured medical reimbursement plan, which includes
health FSAs. See Sec. 1.105-11. For purposes of section 105(h),
coverage by a self-insured accident and health plan offered through a
cafeteria plan is an optional benefit (even if only one level and type
of coverage is offered) and, for purposes of the optional benefit rule
in Sec. 1.105-11(c)(3)(i), employer contributions are treated as
employee contributions to the extent that taxable benefits are offered
by the plan.
(m) HSA-compatible FSAs-limited-purpose health FSAs and post-
deductible health FSAs--(1) In general. Limited-purpose health FSAs and
post-deductible health FSAs which satisfy all the requirements of
section 125 are permitted to be offered through a cafeteria plan.
(2) HSA-compatible FSAs. Section 223(a) allows a deduction for
certain contributions to a ``Health Savings Account'' (HSA) (as defined
in section 223(d)). An eligible individual (as defined in section
223(c)(1)) may contribute to an HSA. An eligible individual must be
covered under a ``high deductible health plan'' (HDHP) and not, while
covered under an HDHP, under any health plan which is not an HDHP. A
general purpose health FSA is not an HDHP and an individual covered by
a general purpose health FSA is not eligible to contribute to an HSA.
However, an individual covered by an HDHP (and who otherwise satisfies
section 223(c)(1)) does not fail to be an eligible individual merely
because the individual is also covered by a limited-purpose health FSA
or post-deductible health FSA (as defined in this paragraph (m)) or a
combination of a limited-purpose health FSA and a post-deductible
health FSA.
(3) Limited-purpose health FSA. A limited-purpose health FSA is a
health FSA described in the cafeteria plan that only pays or reimburses
permitted coverage benefits (as defined in section 223(c)(2)(C)), such
as vision care, dental care or preventive care (as defined for purposes
of section 223(c)(2)(C)). See paragraph (k) in this section.
(4) Post-deductible health FSA--(i) In general. A post-deductible
health FSA is a health FSA described in the cafeteria plan that only
pays or reimburses medical expenses (as defined in section 213(d)) for
preventive care or medical expenses incurred after the minimum annual
HDHP deductible under section 223(c)(2)(A)(i) is satisfied. See
paragraph (k) in this section. No medical expenses incurred before the
annual HDHP deductible is satisfied may be reimbursed by a post-
deductible FSA, regardless of whether the HDHP covers the expense or
whether the deductible is later satisfied. For example, even if
chiropractic care is not covered under the HDHP, expenses for
chiropractic care incurred before the HDHP deductible is satisfied are
not reimbursable at any time by a post-deductible health FSA.
(ii) HDHP and health FSA deductibles. The deductible for a post-
deductible health FSA need not be the same amount as the deductible for
the HDHP, but in no event may the post-deductible health FSA or other
coverage provide benefits before the minimum annual HDHP deductible
under section 223(c)(2)(A)(i) is satisfied (other than benefits
permitted under a limited-purpose health FSA). In addition, although
the deductibles of the HDHP and the other coverage may be satisfied
independently by separate expenses, no benefits may be paid before the
minimum annual deductible under section 223(c)(2)(A)(i) has been
satisfied. An individual covered by a post-deductible health FSA (if
otherwise an eligible individual) is an eligible individual for the
purpose of contributing to the HSA.
(5) Combination of limited-purpose health FSA and post-deductible
health FSA. An FSA is a combination of a limited-purpose health FSA and
post-deductible health FSA if each of the benefits and reimbursements
provided under the FSA are permitted under either a limited-purpose
health FSA or post-deductible health FSA. For example, before the HDHP
deductible is satisfied, a combination limited-purpose and post-
deductible health FSA may reimburse only preventive, vision or dental
expenses. A combination limited-purpose and post-deductible health FSA
may also reimburse any medical expense that may otherwise be paid by an
FSA (that is, no insurance premiums or long-term care benefits) that is
incurred after the HDHP deductible is satisfied.
(6) Substantiation. The substantiation rules in this section apply
to limited-purpose health FSAs and to post-deductible health FSAs. In
addition to
[[Page 43960]]
providing third-party substantiation of medical expenses, 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 care, dental care or preventive care.
(7) Plan amendments. See paragraph (c) in Sec. 1.125-1 on the
required effective date for amendments adopting or changing limited-
purpose, post-deductible or combination limited-purpose and post-
deductible health FSAs.
(n) Qualified HSA distributions--(1) In general. A health FSA in a
cafeteria plan is permitted to offer employees the right to elect
qualified HSA distributions described in section 106(e). No qualified
HSA distribution may be made in a plan year unless the employer amends
the health FSA written plan with respect to all employees, effective by
the last day of the plan year, to allow a qualified HSA distribution
satisfying all the requirements in this paragraph (n). See also section
106(e)(5)(B). In addition, a distribution with respect to an employee
is not a qualified HSA distribution unless all of the following
requirements are satisfied--
(i) No qualified HSA distribution has been previously made on
behalf of the employee from this health FSA;
(ii) The employee elects to have the employer make a qualified HSA
distribution from the health FSA to the HSA of the employee;
(iii) The distribution does not exceed the lesser of the balance of
the health FSA on--
(A) September 21, 2006; or
(B) The date of the distribution;
(iv) For purposes of this paragraph (n)(1), balances as of any date
are determined on a cash basis, without taking into account expenses
incurred but not reimbursed as of a date, and applying the uniform
coverage rule in paragraph (d) in this section;
(v) The distribution is made no later than December 31, 2011; and
(vi) The employer makes the distribution directly to the trustee of
the employee's HSA.
(2) Taxation of qualified HSA distributions. A qualified HSA
distribution from the health FSA covering the participant to his or her
HSA is a rollover to the HSA (as defined in section 223(f)(5)) and thus
is generally not includible in gross income. However, if the
participant is not an eligible individual (as defined in section
223(c)(1)) at any time during a testing period following the qualified
HSA distribution, the amount of the distribution is includible in the
participant's gross income and he or she is also subject to an
additional 10 percent tax (with certain exceptions). Section 106(e)(3).
(3) No effect on health FSA elections, coverage, use-or-lose rule.
A qualified HSA distribution does not alter an employee's irrevocable
election under paragraph (a) of Sec. 1.125-2, or constitute a change
in status under Sec. 1.125-4(a). If a qualified HSA distribution is
made to an employee's HSA, even if the balance in a health FSA is
reduced to zero, the employee's health FSA coverage continues to the
end of the plan year. Unused benefits and contributions remaining at
the end of a plan year (or at the end of a grace period, if applicable)
must be forfeited.
(o) FSA experience gains or forfeitures--(1) Experience gains in
general. An FSA experience gain (sometimes referred to as forfeitures
in the use-or-lose rule in paragraph (c) in this section) with respect
to a plan year (plus any grace period following the end of a plan year
described in paragraph (e) in Sec. 1.125-1), equals the amount of the
employer contributions, including salary reduction contributions, and
after-tax employee contributions to the FSA minus the FSA's total
claims reimbursements for the year. Experience gains (or forfeitures)
may be--
(i) Retained by the employer maintaining the cafeteria plan; or
(ii) If not retained by the employer, may be used only in one or
more of the following ways--
(A) To reduce required salary reduction amounts for the immediately
following plan year, on a reasonable and uniform basis, as described in
paragraph (o)(2) of this section;
(B) Returned to the employees on a reasonable and uniform basis, as
described in paragraph (o)(2) of this section; or
(C) To defray expenses to administer the cafeteria plan.
(2) Allocating experience gains among employees on reasonable and
uniform basis. If not retained by the employer or used to defray
expenses of administering the plan, the experience gains must be
allocated among employees on a reasonable and uniform basis. It is
permissible to allocate these amounts based on the different coverage
levels of employees under the FSA. Experience gains allocated in
compliance with this paragraph (o) are not a deferral of the receipt of
compensation. However, in no case may the experience gains be allocated
among employees based (directly or indirectly) on their individual
claims experience. Experience gains may not be used as contributions
directly or indirectly to any deferred compensation benefit plan.
(3) Example. The following example illustrates the rules in this
paragraph (o):
Example. Allocating experience gains. (i) Employer L maintains a
cafeteria plan for its 1,200 employees, who may elect one of several
different annual coverage levels under a health FSA in $100
increments from $500 to $2,000.
(ii) For the 2009 plan year, 1,000 employees elect levels of
coverage under the health FSA. For the 2009 plan year, the health
FSA has an experience gain of $5,000.
(iii) The $5,000 may be allocated to all participants for the
plan year on a per capita basis weighted to reflect the
participants' elected levels of coverage.
(iv) Alternatively, the $5,000 may be used to reduce the
required salary reduction amount under the health FSA for all 2009
participants (for example, a $500 health FSA for the next year is
priced at $480) or to reimburse claims incurred above the elective
limit in 2010 as long as such reimbursements are made on a
reasonable and uniform level.
(p) Effective/applicability date. It is proposed that these
regulations apply on and after plan years beginning on or after January
1, 2009.
Sec. 1.125-6 Substantiation of expenses for all cafeteria plans.
(a) Cafeteria plan payments and reimbursements--(1) In general. A
cafeteria plan may pay or reimburse only those substantiated expenses
for qualified benefits incurred on or after the later of the effective
date of the cafeteria plan and the date the employee is enrolled in the
plan. This requirement applies to all qualified benefits offered
through the cafeteria plan. See paragraph (b) of this section for
substantiation rules.
(2) Expenses incurred--(i) Employees' medical expenses must be
incurred during the period of coverage. In order for reimbursements to
be excludible from gross income under section 105(b), the medical
expenses reimbursed by an accident and health plan elected through a
cafeteria plan must be incurred during the period when the participant
is covered by the accident and health plan. A participant's period of
coverage includes COBRA coverage. See Sec. 54.4980B-2 of this chapter.
Medical expenses incurred before the later of the effective date of the
plan and the date the employee is enrolled in the plan are not incurred
during the period for which the employee is covered by the plan.
However, the actual reimbursement of covered medical care expenses may
be made after the applicable period of coverage.
[[Page 43961]]
(ii) When medical expenses are incurred. For purposes of this rule,
medical expenses are incurred when the employee (or the employee's
spouse or dependents) is provided with the medical care that gives rise
to the medical expenses, and not when the employee is formally billed,
charged for, or pays for the medical care.
(iii) Example. The following example illustrates the rules in this
paragraph (a)(2):
Example. Medical expenses incurred after termination. (i)
Employer E maintains a cafeteria plan with a calendar year plan
year. The cafeteria plan provides that participation terminates when
an individual ceases to be an employee of Employer E, unless the
former employee elects to continue to participate in the health FSA
under the COBRA rules in Sec. 54.4980B-2 of this chapter. Employee
G timely elects to salary reduce $1,200 to participate in a health
FSA for the 2009 plan year. As of June 30, 2009, Employee G has
contributed $600 toward the health FSA, but incurred no medical
expenses. On June 30, 2009, Employee G terminates employment and
does not continue participation under COBRA. On July 15, 2009, G
incurs a section 213(d) medical expense of $500.
(ii) Under the rules in paragraph (a)(2) of this section, the
cafeteria plan is prohibited from reimbursing any portion of the
$500 medical expense because, at the time the medical expense is
incurred, G is not a participant in the cafeteria plan.
(3) Section 105(b) requirements for reimbursement of medical
expenses through a cafeteria plan--(i) In general. In order for medical
care reimbursements paid to an employee through a cafeteria plan to be
excludible under section 105(b), the reimbursements must be paid
pursuant to an employer-funded accident and health plan, as defined in
section 105(e) and Sec. Sec. 1.105-2 and 1.105-5.
(ii) Reimbursement exclusively for section 213(d) medical expenses.
A cafeteria plan benefit through which an employee receives
reimbursements of medical expenses is excludable under section 105(b)
only if reimbursements from the plan are made specifically to reimburse
the employee for medical expenses (as defined in section 213(d))
incurred by the employee or the employee's spouse or dependents during
the period of coverage. Amounts paid to an employee as reimbursement
are not paid specifically to reimburse the employee for medical
expenses if the plan provides that the employee is entitled, or
operates in a manner that entitles the employee, to receive the
amounts, in the form of cash (for example, routine payment of salary)
or any other taxable or nontaxable benefit irrespective of whether the
employee (or the employee's spouse or dependents) incurs medical
expenses during the period of coverage. This rule applies even if the
employee will not receive such amounts until the end or after the end
of the period. A plan under which employees (or their spouses and
dependents) will receive reimbursement for medical expenses up to a
specified amount and, if they incur no medical expenses, will receive
cash or any other benefit in lieu of the reimbursements is not a
benefit qualifying for the exclusion under sections 106 and 105(b). See
Sec. 1.105-2. This is the case without regard to whether the benefit
was purchased with contributions made at the employer's discretion, at
the employee's discretion (for example, by salary reduction election),
or pursuant to a collective bargaining agreement.
(iii) Other arrangements. Arrangements formally outside of the
cafeteria plan that adjust an employee's compensation or an employee's
receipt of any other benefits on the basis of the expenses incurred or
reimbursements the employee receives are considered in determining
whether the reimbursements are through a plan eligible for the
exclusions under sections 106 and 105(b).
(4) Reimbursements of dependent care expenses--(i) Dependent care
expenses must be incurred. In order to satisfy section 129, dependent
care expenses may not be reimbursed before the expenses are incurred.
For purposes of this rule, dependent care expenses are incurred when
the care is provided and not when the employee is formally billed,
charged for, or pays for the dependent care.
(ii) Dependent care provided during the period of coverage. In
order for dependent care assistance to be provided through a dependent
care assistance program eligible for the section 129 exclusion, the
care must be provided to or on behalf of the employee during the period
for which the employee is covered by the program. For example, if for a
plan year, an employee elects a dependent care assistance program
providing for reimbursement of dependent care expenses, only
reimbursements for dependent care expenses incurred during that plan
year are provided from a dependent care assistance program within the
scope of section 129. Also, for purposes of this rule, expenses
incurred before the later of the program's effective date and the date
the employee is enrolled in the program are not incurred during the
period when the employee is covered by the program. Similarly, if the
dependent care assistance program furnishes the dependent care in-kind
(for example, through an employer-maintained child care facility), only
dependent care provided during the plan year of coverage is provided
through a dependent care assistance program within the meaning of
section 129. See also Sec. 1.125-5 for FSA rules.
(iii) Period of coverage. In order for dependent care assistance
through a cafeteria plan to be provided through a dependent care
assistance program eligible for the section 129 exclusion, the plan may
not operate in a manner that enables employees to purchase dependent
care assistance only for periods during which the employees expect to
receive dependent care assistance. If the period of coverage for a
dependent care assistance program offered through a cafeteria plan is
twelve months (or, in the case of a short plan year, at least equal to
the short plan year) and the plan does not permit an employee to elect
specific amounts of coverage, reimbursement, or salary reduction for
less than twelve months, the plan is deemed not to operate to enable
employees to purchase coverage only for periods when dependent care
assistance will be received. See paragraph (a) in Sec. 1.125-2 and
Sec. 1.125-4 regarding the revocation of elections during the period
of coverage on account of changes in family status. See paragraph (e)
in this section for required period of coverage for dependent care
assistance.
(iv) Examples. The following examples illustrate the rules in
paragraphs (a)(4)(i)-(iii) of this section:
Example 1. Initial non-refundable fee for child care. (i)
Employer F maintains a calendar year cafeteria plan, offering
employees an election between cash and qualified benefits, including
dependent care assistance. Employee M has a one-year old dependent
child. Employee M timely elected $5,000 of dependent care assistance
for 2009. During the entire 2009 plan year, Employee M satisfies all
the requirements in section 129 for dependent care assistance.
(ii) On February 1, 2009, Employee M pays an initial non-
refundable fee of $500 to a licensed child care center (unrelated to
Employer F or to Employee M), to reserve a space at the child care
center for M's child. The child care center's monthly charges for
child care are $1,200. When the child care center first begins to
care for M's child, the $500 non-refundable fee is applied toward
the first month's charges for child care.
(iii) On March 1, 2009, the child care center begins caring for
Employee M's child, and continues to care for the child through
December 31, 2009. On March 1, 2009, M pays the child care center
$700 (the balance of the $1,200 in charges for child care to be
provided in March 2009). On April 1, 2009, M pays the child care
center $1,200 for the child care to be provided in April 2009.
[[Page 43962]]
(iv) Dependent care expenses are incurred when the services are
provided. For dependent care services provided in March 2009, the
$500 nonrefundable fee paid on February 1, 2009, and the $700 paid
on March 1, 2009 may be reimbursed on or after the later of the date
when substantiated or April 1, 2009. For dependent care services
provided in April 2009, the $1,200 paid on April 1, 2009 may be
reimbursed on or after the later of the date when substantiated or
May 1, 2009.
Example 2. Non-refundable fee forfeited. Same facts as Example
1, except that the child care center never cared for M's child (who
was instead cared for at Employer F's onsite child care facility).
Because the child care center never provided child care services to
Employee M's child, the $500 non-refundable fee is not reimbursable.
(v) Optional spend-down provision. At the employer's option, the
written cafeteria plan may provide that dependent care expenses
incurred after the date an employee ceases participation in the
cafeteria plan (for example, after termination) and through the last
day of that plan year (or grace period immediately after that plan
year) may be reimbursed from unused benefits, if all of the
requirements of section 129 are satisfied.
(vi) Example. The following example illustrates the rules in
paragraph (a)(4)(v) of this section:
Example. Terminated employee's post-termination dependent care
expenses. (i) For calendar year 2009, Employee X elects $5,000
salary reduction for dependent care assistance through Employer G's
cafeteria plan. X works for Employer G from January 1 through June
30, 2009, when X terminates employment. As of June 30, 2009, X had
paid $2,500 in salary reduction and had incurred and was reimbursed
for $2,000 of dependent care expenses.
(ii) X does not work again until October 1, 2009, when X begins
work for Employer H. X was employed by Employer H from October 1,
2009 through December 31, 2009. During this period, X also incurred
$500 of dependent care expenses. During all the periods of
employment in 2009, X satisfied all requirements in section 129 for
excluding payments for dependent care assistance from gross income.
(iii) Employer G's cafeteria plan allows terminated employees to
``spend down'' unused salary reduction amounts for dependent care
assistance, if all requirements of section 129 are satisfied. After
X's claim for $500 of dependent care expenses is substantiated,
Employer G's cafeteria plan reimburses X for $500 (the remaining
balance) of dependent care expenses incurred during X's employment
for Employer H between October 1, 2009 and December 31, 2009.
Employer G's cafeteria plan and operation are consistent with
section 125.
(b) Rules for claims substantiation for cafeteria plans--(1)
Substantiation required before reimbursing expenses for qualified
benefits. This paragraph (b) sets forth the substantiation requirements
that a cafeteria plan must satisfy before paying or reimbursing any
expense for a qualified benefit.
(2) All claims must be substantiated. As a precondition of payment
or reimbursement of expenses for qualified benefits, a cafeteria plan
must require substantiation in accordance with this section.
Substantiating only a percentage of claims, or substantiating only
claims above a certain dollar amount, fails to comply with the
substantiation requirements in Sec. 1.125-1 and this section.
(3) Substantiation by independent third-party--(i) In general. All
expenses must be substantiated by information from a third-party that
is independent of the employee and the employee's spouse and
dependents. The independent third-party must provide information
describing the service or product, the date of the service or sale, and
the amount. Self-substantiation or self-certification of an expense by
an employee does not satisfy the substantiation requirements of this
paragraph (b). The specific requirements in sections 105(b), 129, and
137 must also be satisfied as a condition of reimbursing expenses for
qualified benefits. For example, a health FSA does not satisfy the
requirements of section 105(b) if it reimburses employees for expenses
where the employees only submit information describing medical
expenses, the amount of the expenses and the date of the expenses but
fail to provide a statement from an independent third-party (either
automatically or subsequent to the transaction) verifying the expenses.
Under Sec. 1.105-2, all amounts paid under a plan that permits self-
substantiation or self-certification are includible in gross income,
including amounts reimbursed for medical expenses, whether or not
substantiated. See paragraph (m) in Sec. 1.125-5 for additional
substantiation rules for limited-purpose and post-deductible health
FSAs.
(ii) Rules for substantiation of health FSA claims using an
explanation of benefits provided by an insurance company--(A) Written
statement from an independent third-party. If the employer is provided
with information from an independent third-party (such as an
``explanation of benefits'' (EOB) from an insurance company) indicating
the date of the section 213(d) medical care and the employee's
responsibility for payment for that medical care (that is, coinsurance
payments and amounts below the plan's deductible), and the employee
certifies that any expense paid through the health FSA has not been
reimbursed and that the employee will not seek reimbursement from any
other plan covering health benefits, the claim is fully substantiated
without the need for submission of a receipt by the employee or further
review.
(B) Example. The following example illustrates the rules in this
paragraph (b)(3):
Example. Explanation of benefits. (i) During the plan year
ending December 31, 2009, Employee Q is a participant in the health
FSA sponsored by Employer J and is enrolled in Employer J's accident
and health plan.
(ii) On March 1, 2009, Q visits a physician's office for medical
care as defined in section 213(d). The charge for the physician's
services is $150. Under the plan, Q is responsible for 20 percent of
the charge for the physician's services (that is, $30). Q has
sufficient FSA coverage for the $30 claim.
(iii) Employer J has coordinated with the accident and health
plan so that Employer J or its agent automatically receives an EOB
from the plan indicating that Q is responsible for payment of 20
percent of the $150 charged by the physician. Because Employer J has
received a statement from an independent third-party that Q has
incurred a medical expense, the date the expense was incurred, and
the amount of the expense, the claim is substantiated without the
need for J to submit additional information regarding the expense.
Employer J's FSA reimburses Q the $30 medical expense without
requiring Q to submit a receipt or a statement from the physician.
The substantiation rules in paragraph (b) in this section are
satisfied.
(4) Advance reimbursement of expenses for qualified benefits
prohibited. Reimbursing expenses before the expense has been incurred
or before the expense is substantiated fails to satisfy the
substantiation requirements in Sec. 1.105-2, Sec. 1.125-1 and this
section.
(5) Purported loan from employer to employee. In determining
whether, under all the facts and circumstances, employees are being
reimbursed for unsubstantiated claims, special scrutiny will be given
to other arrangements such as employer-to-employee loans based on
actual or projected employee claims.
(6) Debit cards. For purposes of this section, a debit card is a
debit card, credit card, or stored value card. See also paragraphs (c)
through (g) of this section for additional rules on payments or
reimbursements made through debit cards.
(c) Debit cards-overview--(1) Mandatory rules for all debit cards
usable to pay or reimburse medical expenses. Paragraph (d) of this
section sets forth the mandatory procedures for debit cards to
substantiate section 213(d) medical expenses. These rules apply to all
debit cards used to pay or
[[Page 43963]]
reimburse medical expenses. Paragraph (e) of this section sets forth
additional substantiation rules that may be used for medical expenses
incurred at medical care providers and certain stores with the Drug
Stores and Pharmacies merchant category code. Paragraph (f) in this
section sets forth the requirements for an inventory information
approval system which must be used to substantiate medical expenses
incurred at merchants or service providers that are not medical care
providers or certain stores with the Drug Stores and Pharmacies
merchant category code and that may be used for medical expenses
incurred at all merchants.
(2) Debit cards used for dependent care assistance. Paragraph (g)
of this section sets forth additional rules for debit cards usable for
reimbursing dependent care expenses.
(3) Additional guidance. The Commissioner may prescribe additional
guidance of general applicability, published in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2)(ii)(b) of this chapter), to provide
additional rules for debit cards.
(d) Mandatory rules for all debit cards usable to pay or reimburse
medical expenses. A health FSA paying or reimbursing section 213(d)
medical expenses through a debit card must satisfy all of the following
requirements--
(1) Before any employee participating in a health FSA receives the
debit card, the employee agrees in writing that he or she will only use
the card to pay for medical expenses (as defined in section 213(d)) of
the employee or his or her spouse or dependents, that he or she will
not use the debit card for any medical expense that has already been
reimbursed, that he or she will not seek reimbursement under any other
health plan for any expense paid for with a debit card, and that he or
she will acquire and retain sufficient documentation (including
invoices and receipts) for any expense paid with the debit card.
(2) The debit card includes a statement providing that the
agreements described in paragraph (d)(1) of this section are reaffirmed
each time the employee uses the card.
(3) The amount available through the debit card equals the amount
elected by the employee for the health FSA for the cafeteria plan year,
and is reduced by amounts paid or reimbursed for section 213(d) medical
expenses incurred during the plan year.
(4) The debit card is automatically cancelled when the employee
ceases to participate in the health FSA.
(5) The employer limits use of the debit card to--
(i) Physicians, dentists, vision care offices, hospitals, other
medical care providers (as identified by the merchant category code);
(ii) Stores with the merchant category code for Drugstores and
Pharmacies if, on a location by location basis, 90 percent of the
store's gross receipts during the prior taxable year consisted of items
which qualify as expenses for medical care described in section 213(d);
and
(iii) Stores that have implemented the inventory information
approval system under paragraph (f).
(6) The employer substantiates claims based on payments to medical
care providers and stores described in paragraphs (d)(5)(i) and (ii) of
this section in accordance with either paragraph (e) or paragraph (f)
of this section.
(7) The employer follows all of the following correction procedures
for any improper payments using the debit card--
(i) Until the amount of the improper payment is recovered, the
debit card must be de-activated and the employee must request payments
or reimbursements of medical expenses from the health FSA through other
methods (for example, by submitting receipts or invoices from a
merchant or service provider showing the employee incurred a section
213(d) medical expense);
(ii) The employer demands that the employee repay the cafeteria
plan an amount equal to the improper payment;
(iii) If, after the demand for repayment of improper payment (as
described in paragraph (d)(7)(ii) of this section), the employee fails
to repay the amount of the improper charge, the employer withholds the
amount of the improper charge from the employee's pay or other
compensation, to the full extent allowed by applicable law;
(iv) If any portion of the improper payment remains outstanding
after attempts to recover the amount (as described in paragraph
(d)(7)(ii) and (iii) of this section), the employer applies a claims
substitution or offset to resolve improper payments, such as a
reimbursement for a later substantiated expense claim is reduced by the
amount of the improper payment. So, for example, if an employee has
received an improper payment of $200 and subsequently submits a
substantiated claim for $250 incurred during the same coverage period,
a reimbursement for $50 is made; and
(v) If, after applying all the procedures described in paragraph
(d)(7)(ii) through (iv) of this section, the employee remains indebted
to the employer for improper payments, the employer, consistent with
its business practice, treats the improper payment as it would any
other business indebtedness.
(e) Substantiation of expenses incurred at medical care providers
and certain other stores with Drug Stores and Pharmacies merchant
category code--(1) In general. A health FSA paying or reimbursing
section 213(d) medical expenses through a debit card is permitted to
comply with the substantiation provisions of this paragraph (e),
instead of complying with the provisions of paragraph (f), for medical
expenses incurred at providers described in paragraph (e)(2) of this
section.
(2) Medical care providers and certain other stores with Drug
Stores and Pharmacies merchant category code. Medical expenses may be
substantiated using the methods described in paragraph (e)(3) of this
section if incurred at physicians, pharmacies, dentists, vision care
offices, hospitals, other medical care providers (as identified by the
merchant category code) and at stores with the Drug Stores and
Pharmacies merchant category code, if, on a store location-by-location
basis, 90 percent of the store's gross receipts during the prior
taxable year consisted of items which qualify as expenses for medical
care described in section 213(d).
(3) Claims substantiation for copayment matches, certain recurring
medical expenses and real-time substantiation. If all of the
requirements in this paragraph (e)(3) are satisfied, copayment matches,
certain recurring medical expenses and medical expenses substantiated
in real-time are substantiated without the need for submission of
receipts or further review.
(i) Matching copayments--multiples of five or fewer. If an
employer's accident or health plan covering the employee (or the
employee's spouse or dependents) has copayments in specific dollar
amounts, and the dollar amount of the transaction at a medical care
provider equals an exact multiple of not more than five times the
dollar amount of the copayment for the specific service (for example,
pharmacy benefit copayment, copayment for a physician's office visit)
under the accident or health plan covering the specific employee-
cardholder, then the charge is fully substantiated without the need for
submission of a receipt or further review.
(A) Tiered copayments. If a health plan has multiple copayments for
the same benefit, (for example, tiered
[[Page 43964]]
copayments for a pharmacy benefit), exact matches of multiples or
combinations of up to five copayments are similarly fully substantiated
without the need for submission of a receipt or further review.
(B) Copayment match must be exact multiple. If the dollar amount of
the transaction is not an exact multiple of the copayment (or an exact
match of a multiple or combination of different copayments for a
benefit in the case of multiple copayments), the transaction must be
treated as conditional pending confirmation of the charge, even if the
amount is less than five times the copayment.
(C) No match for multiple of six or more times copayment. If the
dollar amount of the transaction at a medical care provider equals a
multiple of six or more times the dollar amount of the copayment for
the specific service, the transaction must be treated as conditional
pending confirmation of the charge by the submission of additional
third-party information. See paragraph (d) of this section. In the case
of a plan with multiple copayments for the same benefit, if the dollar
amount of the transaction exceeds five times the maximum copayment for
the benefit, the transaction must also be treated as conditional
pending confirmation of the charge by the submission of additional
third-party information. In these cases, the employer must require that
additional third-party information, such as merchant or service
provider receipts, be submitted for review and substantiation, and the
third-party information must satisfy the requirements in paragraph
(b)(3) of this section.
(D) Independent verification of copayment required. The copayment
schedule required under the accident or health plan must be
independently verified by the employer. Statements or other
representations by the employee are not sufficient. Self-substantiation
or self-certification of an employee's copayment in connection with
copayment matching procedures through debit cards or otherwise does not
constitute substantiation. If a plan's copayment matching system relies
on an employee to provide a copayment amount without verification of
the amount, claims have not been substantiated, and all amounts paid
from the plan are included in gross income, including amounts paid for
medical care whether or not substantiated. See paragraph (b) in this
section.
(4) Certain recurring medical expenses. Automatic payment or
reimbursement satisfies the substantiation rules in this paragraph (e)
for payment of recurring expenses that match expenses previously
approved as to amount, medical care provider and time period (for
example, for an employee who refills a prescription drug on a regular
basis at the same provider and in the same amount). The payment is
substantiated without the need for submission of a receipt or further
review.
(5) Real-time substantiation. If a third party that is independent
of the employee and the employee's spouse and dependents (for example,
medical care provider, merchant, or pharmacy benefit manager) provides,
at the time and point of sale, information to verify to the employer
(including electronically by email, the internet, intranet or
telephone) that the charge is for a section 213(d) medical expense, the
expense is substantiated without the need for further review.
(6) Substantiation requirements for all other medical expenses paid
or reimbursed through a health FSA debit card. All other charges to the
debit card (other than substantiated copayments, recurring medical
expenses or real-time substantiation, or charges substantiated through
the inventory information approval system described in paragraph (f) of
this section) must be treated as conditional, pending substantiation of
the charge through additional independent third-party information
describing the goods or services, the date of the service or sale and
the amount of the transaction. All such debit card payments must be
substantiated, regardless of the amount of the payment.
(f) Inventory information approval system--(1) In general. An
inventory information approval system that complies with this paragraph
(f) may be used to substantiate payments made using a debit card,
including payments at merchants and service providers that are not
described in paragraph (e)(2) of this section. Debit card transactions
using this system are fully substantiated without the need for
submission of a receipt by the employee or further review.
(2) Operation of inventory information approval system. An
inventory information approval system must operate in the manner
described in this paragraph (f)(2).
(i) When an employee uses the card, the payment card processor's or
participating merchant's system collects information about the items
purchased using the inventory control information (for example, stock
keeping units (SKUs)). The system compares the inventory control
information for the items purchased against a list of items, the
purchase of which qualifies as expenses for medical care under section
213(d) (including nonprescription medications).
(ii) The section 213(d) medical expenses are totaled and the
merchant's or payment card processor's system approves the use of the
card only for the amount of the section 213(d) medical expenses
eligible for coverage under the health FSA (taking into consideration
the uniform coverage rule in paragraph (d) of Sec. 1.125-5);
(iii) If the transaction is only partially approved, the employee
is required to tender additional amounts, resulting in a split-tender
transaction. For example, if, after matching inventory information, it
is determined that all items purchased are section 213(d) medical
expenses, the entire transaction is approved, subject to the coverage
limitations of the health FSA;
(iv) If, after matching inventory information, it is determined
that only some of the items purchased are section 213(d) medical
expenses, the transaction is approved only as to the section 213(d)
medical expenses. In this case, the merchant or service-provider must
request additional payment from the employee for the items that do not
satisfy the definition of medical care under section 213(d);
(v) The merchant or service-provider must also request additional
payment from the employee if the employee does not have sufficient
health FSA coverage to purchase the section 213(d) medical items;
(vi) Any attempt to use the card at non-participating merchants or
service-providers must fail.
(3) Employer's responsibility for ensuring inventory information
approval system's compliance with Sec. 1.105-2, Sec. 1.125-1, Sec.
1.125-6 and recordkeeping requirements. An employer that uses the
inventory information approval system must ensure that the inventory
information approval system complies with the requirements in
Sec. Sec. 1.105-2, 1.125-1, and Sec. 1.125-6 for substantiating,
paying or reimbursing section 213(d) medical expenses and with the
recordkeeping requirements in section 6001.
(g) Debit cards used to pay or reimburse dependent care
assistance--(1) In general. An employer may use a debit card to provide
benefits under its dependent care assistance program (including a
dependent care assistance FSA). However, dependent care expenses may
not be reimbursed before the expenses are incurred. See paragraph
(a)(4) in this section. Thus, if a dependent care provider requires
[[Page 43965]]
payment before the dependent care services are provided, the expenses
cannot be reimbursed at the time of payment through use of a debit card
or otherwise.
(2) Reimbursing dependent care assistance through a debit card. An
employer offering a dependent care assistance FSA may adopt the
following method to provide reimbursements for dependent care expenses
through a debit card--
(i) At the beginning of the plan year or upon enrollment in the
dependent care assistance program, the employee pays initial expenses
to the dependent care provider and substantiates the initial expenses
by submitting to the employer or plan administrator a statement from
the dependent care provider substantiating the dates and amounts for
the services provided.
(ii) After the employer or plan administrator receives the
substantiation (but not before the date the services are provided as
indicated by the statement provided by the dependent care provider),
the plan makes available through the debit card an amount equal to the
lesser of--
(A) The previously incurred and substantiated expense; or
(B) The employee's total salary reduction amount to date.
(iii) The card may be used to pay for subsequently incurred
dependent care expenses.
(iv) The amount available through the card may be increased in the
amount of any additional dependent care expenses only after the
additional expenses have been incurred.
(3) Substantiating recurring dependent care expenses. Card
transactions that collect information matching expenses previously
substantiated and approved as to dependent care provider and time
period may be treated as substantiated without further review if the
transaction is for an amount equal to or less than the previously
substantiated expenses. Similarly, dependent care expenses previously
substantiated and approved through nonelectronic methods may also be
treated as substantiated without further review. In both cases, if
there is an increase in previously substantiated amounts or a change in
the dependent care provider, the employee must submit a statement or
receipt from the dependent care provider substantiating the claimed
expenses before amounts relating to the increased amounts or new
providers may be added to the card.
(4) Example. The following example illustrates the rules in this
paragraph (g):
Example. Recurring dependent care expenses. (i) Employer K
sponsors a dependent care assistance FSA through its cafeteria plan.
Salary reduction amounts for participating employees are made on a
weekly payroll basis, which are available for dependent care
coverage on a weekly basis. As a result, the amount of available
dependent care coverage equals the employee's salary reduction
amount minus claims previously paid from the plan. Employer K has
adopted a payment card program for its dependent care FSA.
(ii) For the plan year ending December 31, 2009, Employee F is a
participant in the dependent care FSA and elected $5,000 of
dependent care coverage. Employer K reduces F's salary by $96.15 on
a weekly basis to pay for coverage under the dependent care FSA.
(iii) At the beginning of the 2009 plan year, F is issued a
debit card with a balance of zero. F's childcare provider, ABC
Daycare Center, requires a $250 advance payment at the beginning of
the week for dependent care services that will be provided during
the week. The dependent care services provided for F by ABC qualify
for reimbursement under section 129. However, because as of the
beginning of the plan year, no services have yet been provided, F
cannot be reimbursed for any of the amounts until the end of the
first week of the plan year (that is, the week ending January 5,
2009), after the services have been provided.
(iv) F submits a claim for reimbursement that includes a
statement from ABC with a description of the services, the amount of
the services, and the dates of the services. Employer K increases
the balance of F's payment card to $96.15 after the services have
been provided (i.e., the lesser of F's salary reduction to date or
the incurred dependent care expenses). F uses the card to pay ABC
$96.15 on the first day of the next week (January 8, 2009) and pays
ABC the remaining balance due for that week ($153.85) by check.
(v) To the extent that this card transaction and each subsequent
transaction is with ABC and is for an amount equal to or less than
the previously substantiated amount, the charges are fully
substantiated without the need for the submission by F of a
statement from the provider or further review by the employer.
However, the subsequent amount is not made available on the card
until the end of the week when the services have been provided.
Employer K's dependent care debit card satisfies the substantiation
requirements of this paragraph (g).
(h) Effective/applicability date. It is proposed that these
regulations apply on and after plan years beginning on or after January
1, 2009. However, the effective dates for the previously issued
guidance on debit cards, which is incorporated in this section, remain
applicable.
Sec. 1.125-7 Cafeteria plan nondiscrimination rules.
(a) Definitions--(1) In general. The definitions set forth in this
paragraph (a) apply for purposes of section 125(b), (c), (e) and (g)
and this section.
(2) Compensation. The term compensation means compensation as
defined in section 415(c)(3).
(3) Highly compensated individual. (i) In general. The term highly
compensated individual means an individual who is--
(A) An officer;
(B) A five percent shareholder (as defined in paragraph (a)(8) of
this section); or
(C) Highly compensated.
(ii) Spouse or dependent. A spouse or a dependent of any highly
compensated individual described in (a)(3)(i) of this section is a
highly compensated individual. Section 125(e).
(4) Highly compensated participant. The term highly compensated
participant means a highly compensated individual who is eligible to
participate in the cafeteria plan.
(5) Nonhighly compensated individual. The term nonhighly
compensated individual means an individual who is not a highly
compensated individual.
(6) Nonhighly compensated participant. The term nonhighly
compensated participant means a participant who is not a highly
compensated participant.
(7) Officer. The term officer means any individual or participant
who for the preceding plan year (or the current plan year in the case
of the first year of employment) was an officer. Whether an individual
is an officer is determined based on all the facts and circumstances,
including the source of the individual's authority, the term for which
he or she is elected or appointed, and the nature and extent of his or
her duties. Generally, the term officer means an administrative
executive who is in regular and continued service. The term officer
implies continuity of service and excludes individuals performing
services in connection with a special and single transaction. An
individual who merely has the title of an officer but not the authority
of an officer, is not an officer. Similarly, an individual without the
title of an officer but who has the authority of an officer is an
officer. Sole proprietorships, partnerships, associations, trusts and
labor organizations also may have officers. See Sec. Sec. 301.7701-1
through -3
(8) Five percent shareholder. A five percent shareholder is an
individual who in either the preceding plan year or current plan year
owns more than five percent of the voting power or value of all classes
of stock of the employer, determined without attribution.
[[Page 43966]]
(9) Highly compensated. The term highly compensated means any
individual or participant who for the preceding plan year (or the
current plan year in the case of the first year of employment) had
compensation from the employer in excess of the compensation amount
specified in section 414(q)(1)(B), and, if elected by the employer, was
also in the top-paid group of employees (determined by reference to
section 414(q)(3)) for such preceding plan year (or for the current
plan year in the case of the first year of employment).
(10) Key employee. A key employee is a participant who is a key
employee within the meaning of section 416(i)(1) at any time during the
preceding plan year. A key employee covered by a collective bargaining
agreement is a key employee.
(11) Collectively bargained plan. A collectively bargained plan is
a plan or the portion of a plan maintained under an agreement which is
a collective bargaining agreement between employee representatives and
one or more employers, if there is evidence that cafeteria plan
benefits were the subject of good faith bargaining between such
employee representatives and such employer or employers.
(12) Year of employment. For purposes of section 125(g)(3)(B)(i), a
year of employment is determined by reference to the elapsed time
method of crediting service. See Sec. 1.410(a)-7.
(13) Premium-only-plan. A premium-only-plan is described in
paragraph (a)(5) in Sec. 1.125-1.
(14) Statutory nontaxable benefits. Statutory nontaxable benefits
are qualified benefits that are excluded from gross income (for
example, an employer-provided accident and health plan excludible under
section 106 or a dependent care assistance program excludible under
section 129). Statutory nontaxable benefits also include group-term
life insurance on the life of an employee includible in the employee's
gross income solely because the coverage exceeds the limit in section
79(a).
(15) Total benefits. Total benefits are qualified benefits and
permitted taxable benefits.
(b) Nondiscrimination as to eligibility--(1) In general. A
cafeteria plan must not discriminate in favor of highly compensated
individuals as to eligibility to participate for that plan year. A
cafeteria plan does not discriminate in favor of highly compensated
individuals if the plan benefits a group of employees who qualify under
a reasonable classification established by the employer, as defined in
Sec. 1.410(b)-4(b), and the group of employees included in the
classification satisfies the safe harbor percentage test or the unsafe
harbor percentage component of the facts and circumstances test in
Sec. 1.410(b)-4(c). (In applying the Sec. 1.410(b)-4 test, substitute
highly compensated individual for highly compensated employee and
substitute nonhighly compensated individual for nonhighly compensated
employee).
(2) Deadline for participation in cafeteria plan. Any employee who
has completed three years of employment (and who satisfies any
conditions for participation in the cafeteria plan that are not related
to completion of a requisite length of employment) must be permitted to
elect to participate in the cafeteria plan no later than the first day
of the first plan year beginning after the date the employee completed
three years of employment (unless the employee separates from service
before the first day of that plan year).
(3) The safe harbor percentage test--(i) In general. For purposes
of the safe harbor percentage test and the unsafe harbor percentage
component of the facts and circumstances test, if the cafeteria plan
provides that only employees who have completed three years of
employment are permitted to participate in the plan, employees who have
not completed three years of employment may be excluded from
consideration. However, if the cafeteria plan provides that employees
are allowed to participate before completing three years of employment,
all employees with less than three years of employment must be included
in applying the safe harbor percentage test and the unsafe harbor
percentage component of the facts and circumstances test. See paragraph
(g) of this section for a permissive disaggregation rule.
(ii) Employees excluded from consideration. In addition, for
purposes of the safe harbor percentage test and the unsafe harbor
percentage component of the facts and circumstances test, the following
employees are excluded from consideration--
(A) Employees (except key employees) covered by a collectively
bargained plan as defined in paragraph (a)(11) of this section;
(B) Employees who are nonresident aliens and receive no earned
income (within the meaning of section 911(d)(2)) from the employer
which constitutes income from sources within the United States (within
the meaning of section 861(a)(3)); and
(C) Employees participating in the cafeteria plan under a COBRA
continuation provision.
(iv) Examples. The following examples illustrate the rules in
paragraph (b) of this section:
Example 1. Same qualified benefit for same salary reduction
amount. Employer A has one employer-provided accident and health
insurance plan. The cost to participants electing the accident and
health plan is $10,000 per year for single coverage. All employees
have the same opportunity to salary reduce $10,000 for accident and
health plan. The cafeteria plan satisfies the eligibility test.
Example 2. Same qualified benefit for unequal salary reduction
amounts. Same facts as Example 1 except the cafeteria plan offers
nonhighly compensated employees the election to salary reduce
$10,000 to pay premiums for single coverage. The cafeteria plan
provides an $8,000 employer flex-credit to highly compensated
employees to pay a portion of the premium, and provides an election
to them to salary reduce $2,000 to pay the balance of the premium.
The cafeteria plan fails the eligibility test.
Example 3. Accident and health plans of unequal value. Employer
B's cafeteria plan offers two employer-provided accident and health
insurance plans: Plan X, available only to highly compensated
participants, is a low-deductible plan. Plan Y, available only to
nonhighly compensated participants, is a high deductible plan (as
defined in section 223(c)(2)). The annual premium for single
coverage under Plan X is $15,000 per year, and $8,000 per year for
Plan Y. Employer B's cafeteria plan provides that highly compensated
participants may elect salary reduction of $15,000 for coverage
under Plan X, and that nonhighly compensated participants may elect
salary reduction of $8,000 for coverage under Plan Y. The cafeteria
plan fails the eligibility test.
Example 4. Accident and health plans of unequal value for
unequal salary reduction amounts. Same facts as Example 3, except
that the amount of salary reduction for highly compensated
participants to elect Plan X is $8,000. The cafeteria plan fails the
eligibility test.
(c) Nondiscrimination as to contributions and benefits--(1) In
general. A cafeteria plan must not discriminate in favor of highly
compensated participants as to contributions and benefits for a plan
year.
(2) Benefit availability and benefit election. A cafeteria plan
does not discriminate with respect to contributions and benefits if
either qualified benefits and total benefits, or employer contributions
allocable to statutory nontaxable benefits and employer contributions
allocable to total benefits, do not discriminate in favor of highly
compensated participants. A cafeteria plan must satisfy this paragraph
(c) with respect to both benefit availability and benefit
[[Page 43967]]
utilization. Thus, a plan must give each similarly situated participant
a uniform opportunity to elect qualified benefits, and the actual
election of qualified benefits through the plan must not be
disproportionate by highly compensated participants (while other
participants elect permitted taxable benefits). Qualified benefits are
disproportionately elected by highly compensated participants if the
aggregate qualified benefits elected by highly compensated
participants, measured as a percentage of the aggregate compensation of
highly compensated participants, exceed the aggregate qualified
benefits elected by nonhighly compensated participants measured as a
percentage of the aggregate compensation of nonhighly compensated
participants. A plan must also give each similarly situated participant
a uniform election with respect to employer contributions, and the
actual election with respect to employer contributions for qualified
benefits through the plan must not be disproportionate by highly
compensated participants (while other participants elect to receive
employer contributions as permitted taxable benefits). Employer
contributions are disproportionately utilized by highly compensated
participants if the aggregate contributions utilized by highly
compensated participants, measured as a percentage of the aggregate
compensation of highly compensated participants, exceed the aggregate
contributions utilized by nonhighly compensated participants measured
as a percentage of the aggregate compensation of nonhighly compensated
participants.
(3) Example. The following example illustrates the rules in
paragraph (c) of this section:
Example. Contributions and benefits test. Employer C's cafeteria
plan satisfies the eligibility test in paragraph (b) of this
section. Highly compensated participants in the cafeteria plan elect
aggregate qualified benefits equaling 5 percent of aggregate
compensation; nonhighly compensated participants elect aggregate
qualified benefits equaling 10 percent of aggregate compensation.
Employer C's cafeteria plan passes the contribution and benefits
test.
(d) Key employees--(1) In general. If for any plan year, the
statutory nontaxable benefits provided to key employees exceed 25
percent of the aggregate of statutory nontaxable benefits provided for
all employees through the cafeteria plan, each key employee includes in
gross income an amount equaling the maximum taxable benefits that he or
she could have elected for the plan year. However, see safe harbor for
premium-only-plans in paragraph (f) of this section.
(2) Example. The following example illustrates the rules in
paragraph (d) of this section:
Example. (i) Key employee concentration test. Employer D's
cafeteria plan offers all employees an election between taxable
benefits and qualified benefits. The cafeteria plan satisfies the
eligibility test in paragraph (b) of this section. Employer D has
two key employees and four nonhighly compensated employees. The key
employees each elect $2,000 of qualified benefits. Each nonhighly
compensated employee also elects $2,000 of qualified benefits. The
qualified benefits are statutory nontaxable benefits.
(ii) Key employees receive $4,000 of statutory nontaxable
benefits and nonhighly compensated employees receive $8,000 of
statutory nontaxable benefits, for a total of $12,000. Key employees
receive 33 percent of statutory nontaxable benefits (4,000/12,000).
Because the cafeteria plan provides more than 25 percent of the
aggregate of statutory nontaxable benefits to key employees, the
plan fails the key employee concentration test.
(e) Safe harbor for cafeteria plans providing health benefits--(1)
In general. A cafeteria plan that provides health benefits is not
treated as discriminatory as to benefits and contributions if:
(i) Contributions under the plan on behalf of each participant
include an amount which equals 100 percent of the cost of the health
benefit coverage under the plan of the majority of the highly
compensated participants similarly situated, or equals or exceeds 75
percent of the cost of the health benefit coverage of the participant
(similarly situated) having the highest cost health benefit coverage
under the plan, and
(ii) Contributions or benefits under the plan in excess of those
described in paragraph (e)(1)(i) of this section bear a uniform
relationship to compensation.
(2) Similarly situated. In determining which participants are
similarly situated, reasonable differences in plan benefits may be
taken into account (for example, variations in plan benefits offered to
employees working in different geographical locations or to employees
with family coverage versus employee-only coverage).
(3) Health benefits. Health benefits for purposes of this rule are
limited to major medical coverage and exclude dental coverage and
health FSAs.
(4) Example. The following example illustrates the rules in
paragraph (e) of this section:
Example. (i) All 10 of Employer E's employees are eligible to
elect between permitted taxable benefits and salary reduction of
$8,000 per plan year for self-only coverage in the major medical
health plan provided by Employer E. All 10 employees elect $8,000
salary reduction for the major medical plan.
(ii) The cafeteria plan satisfies the section 125(g)(2) safe
harbor for cafeteria plans providing health benefits.
(f) Safe harbor test for premium-only-plans--(1) In general. A
premium-only-plan (as defined in paragraph (a)(13) of this section) is
deemed to satisfy the nondiscrimination rules in section 125(c) and
this section for a plan year if, for that plan year, the plan satisfies
the safe harbor percentage test for eligibility in paragraph (b)(3) of
this section.
(2) Example. The following example illustrates the rules in
paragraph (f) of this section:
Example. Premium-only-plan. (i) Employer F's cafeteria plan is a
premium-only-plan (as defined in paragraph (a)(13) of this section).
The written cafeteria plan offers one employer-provided accident and
health plan and offers all employees the election to salary reduce
same amount or same percentage of the premium for self-only or
family coverage. All key employees and all highly compensated
employees elect salary reduction for the accident and health plan,
but only 20 percent of nonhighly compensated employees elect the
accident and health plan.
(ii) The premium-only-plan satisfies the nondiscrimination rules in
section 125(b) and (c) and this section.
(g) Permissive disaggregation for nondiscrimination testing--(1)
General rule. If a cafeteria plan benefits employees who have not
completed three years of employment, the cafeteria plan is permitted to
test for nondiscrimination under this section as if the plan were two
separate plans--
(i) One plan benefiting the employees who completed one day of
employment but less than three years of employment; and
(ii) Another plan benefiting the employees who have completed three
years of employment.
(2) Disaggregated plans tested separately for eligibility test and
contributions and benefits test. If a cafeteria plan is disaggregated
into two separate plans for purposes of nondiscrimination testing, the
two separate plans must be tested separately for both the
nondiscrimination as to eligibility test in paragraph (b) of this
section and the nondiscrimination as to contributions and benefits test
in paragraph (c) of this section.
(h) Optional aggregation of plans for nondiscrimination testing. An
employer who sponsors more than one cafeteria plan is permitted to
aggregate two or more of the cafeteria plans for purposes of
nondiscrimination testing. If two or
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more cafeteria plans are aggregated into a combined plan for this
purpose, the combined plan must satisfy the nondiscrimination as to
eligibility test in paragraph (b) of this section and the
nondiscrimination as to contributions and benefits test in paragraph
(c) of this section, as though the combined plan were a single plan.
Thus, for example, in order to satisfy the benefit availability and
benefit election requirements in paragraph (c)(2) of this section, the
combined plan must give each similarly situated participant a uniform
opportunity to elect qualified benefits and the actual election of
qualified benefits by highly compensated participants must not be
disproportionate. However, if a principal purpose of the aggregation is
to manipulate the nondiscrimination testing requirements or to
otherwise discriminate in favor of highly compensated individuals or
participants, the plans will not be permitted to be aggregated for
nondiscrimination testing.
(i) Employees of certain controlled groups. All employees who are
treated as employed by a single employer under section 414(b), (c),
(m), or (o) are treated as employed by a single employer for purposes
of section 125. Section 125(g)(4); section 414(t).
(j) Time to perform nondiscrimination testing--(1) In general.
Nondiscrimination testing must be performed as of the last day of the
plan year, taking into account all non-excludable employees (or former
employees) who were employees on any day during the plan year.
(2) The following example illustrates the rules in paragraph (j) of
this section:
Example. When to perform discrimination testing. (i) Employer H
employs three employees and maintains a calendar year cafeteria
plan. During the 2009 plan year, Employee J was an employee the
entire calendar year, Employee K was an employee from May 1, through
August 31, 2009, and Employee L worked from January 1, 2009 to April
15, 2009, when he retired.
(ii) Nondiscrimination testing for the 2009 plan year must be
performed on December 31, 2009, taking into account employees J, K,
and L's compensation in the preceding year.
(k) Discrimination in actual operation prohibited. In addition to
not discriminating as to either benefit availability or benefit
utilization, a cafeteria plan must not discriminate in favor of highly
compensated participants in actual operation. For example, a plan may
be discriminatory in actual operation if the duration of the plan (or
of a particular nontaxable benefit offered through the plan) is for a
period during which only highly compensated participants utilize the
plan (or the benefit). See also the key employee concentration test in
section 125(b)(2).
(l) Anti-abuse rule--(1) Interpretation. The provisions of this
section must be interpreted in a reasonable manner consistent with the
purpose of preventing discrimination in favor of highly compensated
individuals, highly compensated participants and key employees.
(2) Change in plan testing procedures. A plan will not be treated
as satisfying the requirements of this section if there are repeated
changes to plan testing procedures or plan provisions that have the
effect of manipulating the nondiscrimination testing requirements of
this section, if a principal purpose of the changes was to achieve this
result.
(m) Tax treatment of benefits in a cafeteria plan--(1)
Nondiscriminatory cafeteria plan. A participant in a nondiscriminatory
cafeteria plan (including a highly compensated participant or key
employee) who elects qualified benefits is not treated as having
received taxable benefits offered through the plan, and thus the
qualified benefits elected by the employee are not includible in the
employee's gross income merely because of the availability of taxable
benefits. But see paragraph (j) in Sec. 1.125-1 on nondiscrimination
rules for sections 79(d), 105(h), 129(d), and 137(c)(2), and
limitations on exclusion.
(2) Discriminatory cafeteria plan. A highly compensated participant
or key employee participating in a discriminatory cafeteria plan must
include in gross income (in the participant's taxable year within which
ends the plan year with respect to which an election was or could have
been made) the value of the taxable benefit with the greatest value
that the employee could have elected to receive, even if the employee
elects to receive only the nontaxable benefits offered.
(n) Employer contributions to employees' Health Savings Accounts.
If an employer contributes to employees' Health Savings Accounts (HSAs)
through a cafeteria plan (as defined in Sec. 54.4980G-5 of this
chapter) those contributions are subject to the nondiscrimination rules
in section 125 and this section and are not subject to the
comparability rules in section 4980G. See Sec. Sec. 54.4980G-0 through
54.4980G-5 of this chapter.
(o) Effective/applicability date. It is proposed that these
regulations apply on and after plan years beginning on or after January
1, 2009.
Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
[FR Doc. E7-14827 Filed 8-3-07; 8:45 am]
BILLING CODE 4830-01-P