The IRS published the new proposed cafeteria plan regulations on August 6, 2007.  The new proposed regulations are effective for plans year starting on or after January 1, 2009.

The new proposed regulations replace six previously issued proposed and temporary regulations under the following:

1.125-1: Qualified and non-qualified benefits in a cafeteria plan

1.125-2: Elections in cafeteria plans

1.125-5: Flexible spending arrangements

1.125-6: Substantiation of expenses

1.125-7: Non-discrimination rules

Two areas that remain unchanged are:

1.125-3- Effect of the Family and Medical Leave Act (FMLA) on the Operation of Cafeteria Plans

1.125-4- Permitted Election Changes

Below are highlights from the new proposed regulations.

· The definition of dependent (section 152) as amended by the Working Families Tax Relief Act of 2004 (WFTRA).

· The addition of the following: adoption assistance (section 137), additional deferred compensation benefits and Health Savings Accounts (sections 223, 125(d)(2)(D) and 4980(G), and qualified HSA distributions from health FSAs (section 106(e)). 

· Incorporated the grace period rules as defined in Notice 2005-42, 2005-86 and modified in 2007-22.

· The previously issued guidance under Notice 2003-43, Notice 2006-69, Notice 2007-2, and Revenue Procedure 98-25, on substantiating, paying and reimbursing expenses fro section 213(d) medical care incurred at a medical care provider when payment is made with a debit card.

· The new regulations also incorporate rules governing limited-purpose or post-deductible FSAs offered in conjunction with an HSA as established in Revenue Ruling 2004-45 and Notice 2005-86.

· The rules on qualified HSA distributions set forth in Notice 2007-22.

· The final regulations on electronic elections, specifically the safe harbor in section 1.401(a)-21 applies to electronic elections, revocations and changes in elections under section 125.

· 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.  Accordingly, Revenue Ruling 2006-36, 2005-24, 2003-102, Notice 2002-45, Revenue Ruling 2002-41 and Revenue Ruling 69-141 are modified with respect to qualified HSA distributions described in section 106(e).

· The new proposed regulations provide rules for dual status individuals and individuals moving between employee and non-employee status.  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.

· 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.  (previously this was only stated as a requirement for an FSA)

· Provide additional guidance on the cafeteria plan non-discrimination rules, such as definitions of key terms, guidance on the eligibility test and the contributions and benefits tests and a safe harbor non-discrimination test for premium only plans.

· Non-Discrimination testing is to be performed at the end of the plan year.

· Group-term life insurance – 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 section 1.79-0, is a prohibited benefit in a cafeteria plan.

· Group-term life insurance - the entire amount of salary reduction and employer flex-credits for group-term life insurance coverage (even if greater than $50,000) on the life of an employee is excludible from an employee’s gross income.

· Group-term life insurance -  the employee includes in gross income the Table 1 cost of the excess coverage minus all after-tax contributions by the employee for group-term life insurance coverage.

· The new proposed regulations 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.   (This new rule does not apply to any employee who terminates employment and is rehired within 30 days or who returns to employment following an unpaid leave of absence of less than 30 days.)

· Cafeteria plan sponsors may retain forfeitures.

· Qualified Benefits that may be salary reduced: (1) Premiums for COBRA continuation coverage under the plan of the employer sponsoring the cafeteria plan or premiums for COBRA continuation coverage of an employee of the employer sponsoring the cafeteria plan.  (2) Premiums for individual policies but not through an FSA.

· 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.

· The new proposed cafeteria plan regulations permit a short plan year for valid business reasons.

· Allow for adoption assistance as a type of FSA.

· Permit contributions to Health Savings Accounts (HSAs).

· Permit 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.

· Permit automatic (default) elections for new or current employees.

· Permit mandatory two-year election for vision or dental insurance.

· Permit salary reductions amounts from the last month of one plan year to pay accident and health insurance premiums for the first month of the immediately following plan year.

· Permit reasonable cafeteria plan administrative fees to be paid through salary reduction amounts.

· Permit electronic elections, revocations and changes in elections.

· The new proposed regulations clarify that sole proprietors, partners, and directors of corporations are not employees and may not participate in a cafeteria plan.

· The new proposed regulations clarify that 2-percent shareholders of an S corporation are not employees and may not participate in a cafeteria plan.

· The new proposed regulations clarify that the written cafeteria plan must specify that only employees may participate in the cafeteria plan.  Employees are common law employees, leased employees, and full-time life insurance salesmen.  Former employees are also employees that may participate in a plan, but a plan may not be maintained predominantly for former employees.

· The new proposed regulations clarify whether certain benefits and plan administration practices defer compensation.   The new proposed regulations permit the following benefit features that apply for more than one plan year:

o lifetime limits on benefits;

o level premiums:

o premium waiver during disability;

o guaranteed renewability of coverage;

o    coverage for specified accidental injury or specific diseases; and

o    the payment of a fixed amount per day for hospitalization

· The new proposed regulations also provide that the following benefits and practices do not defer compensation:

o long-term disability policy paying benefit over more than one plan year;

o    reasonable premium rebates or policy dividends;

o    certain two-year lock-in vision and dental policies;

o    certain advance payments for orthodontia;

o    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;

o    reimbursement of section 213(d) expenses for durable medical equipment; and

o    allocation of experience gains (forfeitures) amount participants.

· The new proposed cafeteria plan regulations permit a cafeteria plan to require employees to elect to pay the employees’ share of any qualified benefit through salary reduction (pre-tax) and not with after-tax employee contributions, but the new proposed regulations allow a cafeteria plan to offer after-tax employee contributions for qualified benefits or paid time off.

· The new proposed cafeteria plan regulations clarify when medical expenses are incurred. 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.

· The new proposed cafeteria plan regulations clarify when dependent care expenses are incurred. 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.

· The new proposed cafeteria plan regulations provide that the employer sponsoring the cafeteria plan may retain forfeitures (new), use forfeitures to defray expenses of administering the plan, or allocate forfeitures among employees contributing through salary reduction on a reasonable and uniform basis. 

            

· Q&A-6(b) in section 1.125-2 (1989)- In what circumstances may participants revoke existing elections and make new elections under a cafeteria plan?  (b) cessation of required contributions.  “a cafeteria plan may provide that a benefit will cease to be provided to an employee if the employee fails to make the require premium payments with respect to the benefit”, because the change in status rules in 1.125-4 superseded this provision of the 1989 proposed regulations.

· Q&A-11 in section 1.125-1 as it related to a qualified legal services plan, which is no longer a qualified benefit.

· The new proposed regulations 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.   If the employer wants to allow this option, the Plan Document 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 under this rule. 

· 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. 

· Cafeteria plan sponsors may retain forfeitures.

For a copy of the complete regulations, please click on the link below:

http://www.dpath.com/news/docs/REG_142695_05_070802.pdf