The Internal Revenue Service (IRS) issued Proposed Regulations on Internal Revenue Code Section 125 plans, commonly referred to as “cafeteria plans,” in 2007. Final regulations are still pending. However, the Proposed Regulations forecast that major changes will be required for cafeteria plans when the IRS issues the Final Regulations.
Plan sponsors must incorporate these changes in documents and in plan operations. Failure to do so may disqualify the plan under the “no tolerance rule.” Unlike qualified retirement plans, cafeteria plans that fail to meet the Code Section 125 regulations as a result of plan document or operational failures will have no recourse through an IRS voluntary correction program – such plans will simply be stripped of their tax-preferred status. In other words, there will be no tolerance for such failures.
With such significant consequences at play when the IRS issues the Final Regulations, the time is ripe for a brief refresher on the major points of compliance. The end of this article also describes the Cafeteria Plan Compliance Program offered by the McGuireWoods LLP Employee Benefits Group to assist employers in meeting the requirements of Code Section 125.
The Proposed Regulations provide that cafeteria plans are the exclusive means by which employers may offer employees a choice between taxable benefits (typically cash compensation) and non-taxable or qualified benefits (for example, coverage under employer-sponsored group medical plans and flexible spending accounts). While a choice between taxable and non-taxable benefits is permitted under cafeteria plans, such plans:
- May not offer taxable benefits other than those explicitly defined in the regulations.
- May not offer non-qualified benefits (such as dependent group term life insurance or education assistance).
As an example, the Proposed Regulations further indicate that plan designs that combine a cafeteria plan with elements of other health and welfare benefits (such as those typically combined under a “wrap plan”) may fail to meet the regulations when offered in one document. Therefore, employers must examine their overall cafeteria plan design to ensure that it complies with the Proposed Regulations.
The Proposed Regulations require that a cafeteria plan be memorialized in a written plan document that complies with certain substantive requirements. These substantive requirements mark a significant change for Code Section 125 plans. For example, the Proposed Regulations include new nondiscrimination rules for cafeteria plans that, if maintained in the Final Regulations, must be included in the written plan document in much the same way that Code Section 401(k) and 401(m) nondiscrimination rules are included in 401(k) plans.
The following list provides a sampling of the substantive requirements for cafeteria plan documents outlined in the Proposed Regulations:
- Benefit Description. The plan must include a specific description of each of the benefits available through the plan, including the period during which the benefits are provided.
- Participation Rules. The plan must define the rules governing participation and provide that all participants in the plan be employees of the sponsoring employer. The Proposed Regulations provide an extensive definition of “employee” and only permit non-employee participants in limited circumstances.
- Election Procedures. The plan must describe the procedures governing an employee’s elections under the plan, including the period when elections may be made and the period with respect to which elections are effective.
- Employer Contributions. The plan must describe the manner in which employer contributions will be made to the plan and the maximum amount of contributions available to employees.
- Nondiscrimination Testing. The plan must describe the new nondiscrimination testing requirements.
Cafeteria plans that offer flexible spending accounts or the purchase or sale of paid time-off have additional documentation requirements under the Proposed Regulations. In addition, any optional administrative features utilized by sponsoring employers, such as grace periods or run-out periods, must be described in the plan document.
The Proposed Regulations dictate several administrative requirements for cafeteria plans, which include the following:
- Adopting a New Plan. A new cafeteria plan must be adopted and effective on or before the first day of the cafeteria plan year. In contrast to the requirements for qualified retirement plans, this provision in the Proposed Regulations appears to require that an employer finalize and execute a new cafeteria plan document on or before the first day of the plan year for such document.
- Plan Amendments. Plan amendments must be in writing and may only be effective for periods after the later of the adoption date or the effective date of the amendment. In addition, if an amendment adds a new benefit, the plan must pay for or reimburse only those expenses for the new benefit incurred after the later of the amendment’s adoption or effective date. Again, in contrast to the requirements for qualified retirement plans, these provisions in the Proposed Regulations appear to require that plan design changes and regulatory updates be approved and adopted prior to the beginning of a plan year if such changes are to be effective for the entire plan year.
- Plan Elections. All elections (except those relating to Health Savings Accounts) must be irrevocable by the earlier of (i) the date when benefits are first currently available, or (ii) the first day of the plan year (or other coverage period). Only plan documents that incorporate the change-in-status rules of Treasury Regulation Section 1.125-4 may permit employees to change or revoke elections after the dates listed in (i) and (ii) above.
Cafeteria Plan Compliance Program
Failure to meet the requirements of Code Section 125 will result in benefits being taxable to all employees participating in the cafeteria plan. Therefore, it is imperative that employers prepare to meet these new requirements now.
To that end, the McGuireWoods LLP Employee Benefits Group has developed a Cafeteria Plan Compliance Program to guide employers through the steps necessary to prepare for the Final Regulations. The program offers an examination of existing plan documents for any required updates, as well as model plan documents that comply with the new rules. The program also guides employers through the process of implementing changes to administrative policies and practices and offers training to ensure that administrative team members are equipped to meet the new requirements.
For additional information on the proposed cafeteria plan regulations or the Compliance Program referenced above, please contact the authors or any member of the McGuireWoods Employee Benefits or Labor & Employment teams.