It should be noted that in the discussion of Flexible Benefit Premium (Cafeteria) Plans, there are many references to various provisions of the Internal Revenue Service Tax Code. These plans are designed primarily for tax benefits for employee and employers.
Flexible Benefit Premium Plans are a result of Title 26, IRS Code Section 125, “Cafeteria Plans,” and are also frequently called simply “Cafeteria Plans” and/or ""Flex Plans." The Cafeteria Plans have developed into an entire new field of employee benefits, particularly with those products that are paid through payroll deduction where the employer may or may not participate in the plans offered. Cafeteria Plans are marketed through a group approach even though most of the plans offered are not "true group" but are employer-endorsed.
Flexible Benefit plans may offer group and/or individual policies, but usually the benefits offered in the Disability Income insurance area are supplemental benefits – supplemental to group health (usually major medical plans), pension plans and life insurance, and not necessarily supplement to group Disability Income insurance, although they certain can be and are frequently offered. Supplemental Disability Income insurance is usually written on an individual basis with payroll deduction, so even if the policies are individual policies, the payment of premiums to the insurer by the employer (payroll deduction to the employee) and the fact that marketing is performed at the worksite and during, before or after work, puts a “group face” on the product.
The products that are usually offered in a Cafeteria Plan will be discussed in more detail later. The Cafeteria Plan must offer at least one nontaxable benefit (health or accident insurance, for example) and a minimum of one taxable benefit.
In the early 1970's, several "Fortune 500" companies formed the "Employers Council on Flexible Compensation" and were successful in lobbying Congress because of the changes in the work force and the increasing cost of health benefits. Section 125 was created by Congress in the Revenue Act of 1978 and added to the Internal Revenue Code. Basically, it allows employers to establish flexible benefit plans, or Cafeteria Plans, under which employees can choose between tax-free benefits and taxable benefits.
F The key to the success of Cafeteria Plans is that participating employees may redirect a portion of their salaries for the purchase of qualified benefits by pre-tax salary deduction(s) instead of after-tax payroll deduction(s).
In many instances, the tax savings may offset the cost of the supplemental coverage.
The Internal Revenue Section 125(d)(1) described a Cafeteria Plan (or flexible benefit plan) is a written plan in which all participants are employees who may choose among two or more benefits consisting of cash and "qualified benefits." A cafeteria cannot provide for deferred compensation, with certain limited exceptions.155Cafeteria Plans may provide for salary reduction contributions by the employee, or some plans provide benefits in addition to salary, but in any event, the effect is to allow the participants to purchase certain benefits with pre-tax dollars.
Some plans may allow for automatic enrollment, in which case the employee's salary is reduced to pay for the "qualified benefits"—unless the employee elects to receive cash.156
The plan must be written and must contain the following items:
In addition to present employees, former employees may be participants—provided the plan has not been established primarily for the benefit of the former employees. Self-employed individuals may not be participants.158
Interestingly, a full time life insurance salesperson, if treated as an employee for Social Security purposes, will be considered as an employee for Cafeteria Plan purposes.159
As indicated elsewhere in this text, when a person performs services for another (the recipient) under a "leased employee" agreement, the leased employee is considered to be an employee for the recipient of the services and further, any contributions or benefits provided by the leasing organization that are attributable to the services performed by the leased employee for the benefit of the recipient, are treated as though such contributions or benefits were provided by the recipient.
All employees of the employer, including those at other locations or with other "divisions" are eligible for the plan unless specifically excluded by the employer. If employees are excluded by the employer, the employer should be aware of nondiscrimination regulations.
Unions and part-time employees, as discussed elsewhere in this text, may not be eligible as union's employees covered by collective bargaining agreements often have their benefits negotiated between the employer and the union. A cafeteria plan, however, may be considered as a negotiable benefit. If there are union employees who are excluded, the union must be named in the plan document, particularly if there are other unions active in the company.
Employees of nonprofit organizations are eligible for Cafeteria plans.
Employees who are employed by a controlled group of corporations, are under common control, or are members of an "affiliated service group" are considered as being employed by a single employer.160
F Contributions used to provide coverage for a non-dependent domestic partner are treated as taxable income. Benefits under flexible spending accounts may not be provided to such a domestic partner, because such accounts can include only nontaxable income.
Qualified benefits can include:
The participants may choose among two or more benefits consisting of cash and qualified benefits. A cash benefit includes not only cash, but a benefit that can be purchased with after-tax dollars, or a benefit whose value is usually treated as taxable compensation to the employee, if the benefit does not defer receipt of compensation.161
The IRS considers a "qualified benefit" as a benefit that is not included in the gross income of the employee because of statutory exclusion as provided by the Tax Code, and such benefit does not deter the participant from receiving compensation.
As with most such regulations, there are exceptions, notably contributions to Archer Medical Savings Accounts (MSAs). Certain qualified scholarships, educational assistance programs, or fringe benefits specifically excluded, are not qualified benefits. It is particularly noticeable that despite intense lobbying by the insurance and long-term care industry, so far any product that is advertised, marketed or offered as long-term care insurance is not a qualified benefit.162
When insurance is offered as a qualified benefit, the actual "benefit" is, of course, coverage under the plan. Certain accident and health benefits are qualified to the extent that such coverage is excluded under the regulations.163
Accidental death coverage offered in a Cafeteria Plan under an individual accident insurance policy is excludable from the employee's income.164
A Cafeteria Plan can offer group term life insurance coverage on participants, and coverage in excess of the $50,000 excludable limit may be offered.165
Health coverage and dependent care assistance under the plan are qualified benefits if they meet certain requirements, as described in detail later.
As a general rule, the Cafeteria Plan cannot provide for deferred compensation of an employee, allow an employee to carry over unused benefits from one plan year to another, or allow participants to purchase benefits that will be offered later in the plan year. In certain situations, a participant may elect to have the employer contribute to a plan in his behalf.
There are three "sub-type" of plans offered under Section 125:
Section 106 or Premium Only Plans. These are the most popular and also the most basic plans.
Section 105 or Unreimbursed Medical Plans.
Section 129 or Dependent Care Plans.
These will be discussed in more detail in this section. One of the fastest growing areas is the "flexible spending accounts" which are also called "full plans.
Payroll Taxes can be divided into those paid by the employee and that covers FICA (7.65%), Federal and State taxes (for illustration use 15% federal and 2.5% state). For the employer, the employer pays an equal FICA of 7.65%, but must also pay Federal Unemployment Tax (FUTA) and State Unemployment Tax (SUTA), which amounts vary by state (as does Worker's Compensation Insurance and Liability insurance carried by nearly all businesses). Note that the total FICA is 15.3%.
It should be noted, for the sake of accuracy, that all states that have state income tax recognize Cafeteria Plans, but in the case of New Jersey and Pennsylvania at the present time, there is a question regarding state income tax exemptions so their respective tax officials should be contacted in this matter.
In the following examples, using $1,000 of compensation, the employee pays insurance premiums after taxes are deducted from gross income, and illustrates how paying those premiums before taxes (pre-tax) reduces taxable income and increased spendable income. NOTE: This figures are for illustration only as rate of taxation vary by filing status and amount of deduction.
EXAMPLE OF TAX SAVINGS
($1,000 employee compensation)
With State Taxes
WITHOUT SECTION 125 WITH SECTION 125
$1,000 Gross (taxable) Income $1,000 Gross Income
-250 Taxes (using 25% see below) -100 Insurance Premiums
$ 750 (Pre-Tax)
-100 Insurance Premiums After Tax 900 Taxable Income
-225 Taxes (25%)
$ 650 Spendable Income $ 675 Spendable Income
(25% for taxes includes 7.65% FICA, assumption 15% Federal and 2.5% State)
TAX SAVINGS: $25
($1,000 employee compensation)
Without State Taxes
WITHOUT SECTION 125 WITH SECTION 125
$1,000 Gross (taxable) Income $1,000 Gross Income
-220 Taxes (using 22% - see below) -100 Insurance Premiums
$ 780 (Pre-Tax)
-100 Insurance Premiums After Tax 900 Taxable Income
-198 Taxes (22%)
$ 680 Spendable Income $ 702 Spendable Income
22% for taxes includes 7.65% FICA, and 15% Federal)
TAX SAVINGS: $22
$22 or $25 may not seem like a lot, but remember, this is only for each $1,000 of compensation. An employee making $20,000 a year could save as much as $500 (or $440) a year which could pay a considerable portion of their insurance premiums so they are, in fact, getting insurance coverage at an extremely low price.
SAVINGS FOR EMPLOYER
A figure often used to illustrate the savings for an employer by using the Cafeteria Plan, is $500,000 annual payroll with 25 employees each earning $20,000 and paying $1,200 annually for Cafeteria Plan benefits. The employer must pay a matching 7.65% for FICA, for a total FICA of $38,250.
If under the Cafeteria Plan, the employees pay a total of $30,000 for their benefits ($1,200 times 25 employees), the taxable payroll can be reduced to $470,000, and therefore, the matching FICA is reduced by $2,295 (7.65% x $470,000 = $35,955. $38,250 - $35,955 = $2,295)
Now it starts to get interesting. Dividing the employer's FICA savings ($2,295) by the profit margin of the company would create the amount that the business would have to generate in revenue to see a net profit of $2,295.
With Flexible Spending Account arrangements, the result is even more interesting: If the amount that the employees spend for pre-tax benefits ($30,000) PLUS flexible spending account (FSA) arrangements of another $50,000, then the employer would gain a tax savings of $6,120.
The most common and most popular plan type under Section 125 Cafeteria Plans is the Premium Only Plan whereby the employees pay their share of the cost of health and accident insurance with pre-tax dollars.
These plans include:
Certain benefits that do not qualify for Section 125 benefits:
Section 105 allows employees to set aside funds to be used to reimburse themselves for certain and specified medical expenses that are not reimbursed from any other source (basically, insurance plans) or claimed as deductions on their income tax. A taxpayer who itemizes deductions can deduct unreimbursed expenses for medical care (which includes dental care) and expenses for prescribed drugs or insulin for himself, spouse and dependents, to the extent that such expenses exceed 7.5% of his adjusted gross income—on a joint return, the 7.5% is based on the combined adjusted gross income of husband and wife.
IRC Section 213 outlines the procedure for an individual taxpayer and encompasses individual income tax reporting, etc., including the definition of "medical care:" … defined as amounts paid (a) for the diagnosis, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure or function of the body; (b) for transportation principally for an essential to such medical care; (c) for qualified long-term care service; or (d) for insurance covering such care or for any qualified long-term care insurance contract.166
The entire annual elected amount must be made available to an employee when a qualified request for reimbursement is submitted under Section 105-unreimbursed medical accounts. These funds must be available irrespective of the amount contributed by the employee at the time of request, which could leave the employer at risk if the employee terminates employment before the end of the plan year. Therefore, an employer may minimize his exposure risk by placing a low cap on the amount that the employee can elect in any plan year.
For unreimbursed medical accounts that are exempt from HIPAA, it is not required that COBRA be offered to the participant who has spent more than what is in his account at the time of the qualifying event. Conversely, if the participant has spent less ("underspent") then COBRA must be offered—it can be stopped at the plan year-end and it is not necessary to offer re-enrollment rights.
Any money that is remaining in either account can not be returned to the participant (known as the "use-it or leave-it" rule).
A participant may not transfer money from a health care account to a dependent care account (or vice-versa). Services must have been incurred during the plan year for which the election amount was redirected. Therefore, employees who participate in one or both flexible spending accounts should be aware that they cannot "switch money around" at their pleasure so they should carefully determine where they want their contributions to go.
EXAMPLES OF ELIGIBLE REIMBURSEMENT ACCOUNT EXPENSES167
*To be eligible under a Health FSA/URM account, the medical expense(s) must not be reimbursed from any other source and must be an expense for medical care as defined by IRC Section 213(d) and not prohibited under applicable law (e.g., IRC section 125) or the Plan Document and Summary Plan Description (SPD).
EXAMPLES OF INELIGIBLE REIMBURSEMENT ACCOUNT EXPENSES*
The following expenses are not eligible for reimbursement under a Section 105 Unreimbursed Medical Expense Program.
*This list is intended to be representative of the types of expenses that may not be reimbursed. It is not intended to be complete, as other expenses may also be ineligible under federal tax law or under the plan. To be eligible under a Health FSA/URM account, the medical expense(s) must not be reimbursed from any other source and must be an expense for medical care as defined by IRC Section 213(d) and not prohibited under applicable law (e.g., IRC Section 125) or the Plan Document and Summary Plan Description (SPD).
A Section 125 Cafeteria Plan may offer reimbursement for specified dependent care expenses for participant's eligible children &/or other dependents. For these expenses to be reimbursed, they must be incurred so as to allow an employee and spouse to work, unless the spouse is a full-time student or incapable of self-care. These expenses are reimbursed if the dependent is under age 13, or is a spouse or other dependent (so claimed on the participant's income tax) that is physically or mentally incapable of self-care, and spends a minimum of eight hours a day in the participant's household.
Child care expenses (as eligible under the plan) may be provided either inside or outside of the home. A person who is claimed as a dependent for tax purposes, may not provide the child care services. Often these services can be provided by day-care facilities, however, any such facility that care for seven or more children, must comply with applicable state or local requirements and laws and be property licensed as such. Preschool costs for a child may qualify for reimbursement.
The maximum dependent day care expenses reimbursed is typically $5,000 per calendar year, the employee's annual income, or the employee's spouse's annual income, whichever is lower. In the case of a married individual filing separately, the excludable amount is limited $2,500.
While there is no financial risk to the employer with these plans, the "use-it or lose-it" rule applies to an employee so care should be taken to carefully consider the amount of the elections.
The dependant care assistance program is a separate written plan of an employer for the exclusive purpose of providing employees with payment for or the provision of services, which, if paid for by the employee, would be considered employment-related expenses.168
Non-highly compensated employees may exclude from income a limited amount for services paid or incurred by the employer under such a program provided during a taxable year. For the highly compensated employees to have the same income tax exclusion, the program must meet rather stringent anti-discrimination requirements, including the requirement that the average benefits provided to non-highly compensated employees under all plans of the employer must equal at least 55% of the average benefits provided to the highly compensated employees under all plans of the employer.169
It should be noted that an employee cannot exclude from gross income any amount paid to an individual with respect to whom the employee or the employee's spouse is entitled to take a personal exemption deduction, or who is a child of the employee under age 19 at close of the taxable year.
If the benefits are provided through a salary reduction agreement, the plan may disregard any employee with compensation less than $25,000 for purposes of the 55% test (above).
As with most such programs, the employer may exclude from participation employees under the age of 21 who have completed one year or service and those employees are covered by a collective bargaining agreement.170
As a general rule, the employer's expenses incurred in providing benefits under a dependent care assistance program are deductible to the employer as ordinary and necessary business expenses.171
The employee cannot exclude from gross income any amount paid or incurred by the employer for dependent care assistance unless the name, address and taxpayer identification number of the person providing the services are included on the return. If this information was not provided and the taxpayer exercised due diligence in attempting to do so, the amount shall not be included in the employee's gross income.172
It should be noted that the IRS under IRC Section 603D requires the employer to file an information report annually with the IRS which requires such information as number of employees, number of eligible employees, number of employees participating in the plan, number of highly compensated employees (the number of then-eligible to participate and number that actually are participating), the identity of the employer, and the type of business in which it is engaged. However, these reporting requirements are suspended for dependent care assistance plans.173
A flexible spending arrangement (FSA) may allow a grace period of no more than 2 ½ months following the end of the plan year for the participants to incur and submit expenses for reimbursement. If a plan document is amended to include a grace period, a participant who has unusual benefits or contributions relating to a particularly qualified benefit 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 in the immediately preceding plan year. The effect of the grace period, therefore, is that the participant may have as long as 14 months and 15 days (the 12 months in the current plan plus the grace period) to use the benefit or contributions for a plan year before those amounts are forfeited (under the use-it or lose-it rule).174
A person participating in a Cafeteria Plan may elect to have the employer contribute to a Health Savings Account (HSA [discussed later]) on his behalf; and unused balances in a HSA funded through a Cafeteria Plan can be carried over from one year to the next.175
Basically, life, health, disability or long-term care insurance with an investment feature (such as whole life insurance) or which provides for the reimbursement for premium payments that extent beyond the end of the plan year, cannot be purchased. However, supplemental health insurance policies which provide coverage for cancer and other specific diseases do not result in the deferral of compensation, and are, therefore, properly considered accident and health benefits under a Cafeteria Plan.176
As pointed out in "2006 Tax Facts on Insurance and Employee Benefits," an educational organization that meets the IRS requirements can allow participants to elect postretirement term life insurance coverage. This coverage must be fully paid up on retirement and is not allowed to have a cash surrender value at any time. Any life insurance meeting these requirements will be treated as group term life insurance.177
Highly compensated and "key" employees may participate in the Cafeteria Plan if the plan meets certain nondiscrimination requirements and does not allow for the concentration of benefits in key employees.
NOTE: If disability (or "salary continuance") insurance is sold with a pre-tax premium, the benefits will be payable at time of claim. In such a situation, the employee will be subject to income taxes on the benefits received for the duration of the disability. This benefit would be subject to FICA taxes for the employee and (matching) for the employer for the first six months of paid benefits. Some insurers will deduct the employee's FICA tax from the claim check and send it to the IRS, along with notification to the employer of matching FICA funds. In these cases, the disability benefit will appear on the employee's W-2 tax form as taxable income.
In order for an employee to take advantage of the "tax breaks" of a Cafeteria Plan, the participant in such a plan is not treated as being in "constructive" receipt of taxable income solely because he has the opportunity—before a cash benefit becomes available—to elect among cash and "qualified" (or non-taxable) benefits.‑178
However, the election must be made before the specified period for which the benefit that will be provided, begins (usually the plan year).179
Simply put, if the plan discriminates in favor of highly compensated individuals either by contributions or benefits, then such individuals will be considered as being in (constructive) receipt of the available cash benefit.180 Those who are "highly compensated" consist of officers, shareholders owning more than 5% of the voting power of the stock, those who are highly compensated, or a spouse or dependant of any of them.181
Conversely, the participation will be considered as nondiscriminatory if it does not discriminate in favor of employees who are officers, shareholders or highly compensated (as determined by the Secretary of the Treasury). Further, not more than three years of employment may be required for participation—such requirement being the same for all employees; and the requirement that all employees who are eligible begin to participate in the plan by the first day of the first plan year after the employment requirement, is satisfied.182
There is another rule that allows that a plan will not be discriminatory in respect to benefits under the Cafeteria Plan for highly compensated employees as determined by using a percentage of compensation, if such benefits are not "significantly" higher (or lower) than the total benefits or nontaxable benefits that are provided for other employees measured by the same basis, and provided the plan is not otherwise discriminatory.183
If the Cafeteria Plan offers health benefits, then the plan is not considered as being discriminatory in respect to either contributions and/or benefits, if two requirements are met:
Note: A plan is considered as satisfying all discrimination requirements if it is maintained under a collective bargaining agreement between representatives of the employees and one or more employers.185
In respect to the nondiscrimination rules, a key employee (as defined in the tax code) will be considered as not in constructive receipt of the available cash benefit option in any plan year in which nontaxable benefits that are provided under the plan to key employees exceed 25% of the total of such benefits that are provided to all employees under the plan. Excess group term life insurance that is included in income will be considered as a taxable benefit.186
Any amount that the employer contributes to a Cafeteria Plan because of and pursuant to a salary reduction agreement, will be treated for tax purposes as employer contributions to the extent the agreement relates to compensation that has not been received, either actually or constructively, by the employee as of the agreement date, and does not subsequently become available to the employee.187
The tax rules are rather stringent as to an employee changing a benefit election. Generally, an employee may be permitted to revoke an election for coverage under a group health plan and make a new election as allowed by the tax code188 which pertains to situations where persons lose other group health plan coverage and dependent beneficiaries.189
Certain changes can be made in respect to a judgment, decree or other resulting from a divorce, legal separation, annulment, or change in legal custody or qualified medical child support order—that requires accident or health coverage for the child of an employee or for a dependent foster child of the employee. The plan may permit the employee to make an election change to cancel coverage for the child if an order requires the spouse, former spouse, or other individual to provide coverage for the child (and the coverage is so provided).190
If an employee, spouse or dependent enrolled in the accident or health plan becomes qualified for Medicare Part A or Part B, the plan may allow the employee to make an adjustment to the plan accordingly. Conversely, if an employee had been entitled to Medicare or Medicaid coverage and they lose their eligibility for such coverage, provision may be made to start or increase coverage of that employee, spouse or dependant accident or health plan.191
An employee that takes a leave pursuant to the Family and Medical Leave Act (FMLA) may revoke such accident or health coverage and make an election as provided for by the FMLA for the remaining period of coverage.192
A Cafeteria Plan may allow an employee to revoke an election during a period of coverage in regards to a qualified benefits plan, and allow them to make a new election for the remaining period of coverage if a change in status occurs and the election change meets the "consistency rule" (as discussed below).193 Such changes in status events are:
The before-mentioned consistency rule states that:
F an election change cannot be made for accident or health coverage or group term life insurance, unless it is on account of or corresponds with a change in status that affects eligibility for coverage under the plan.
If a dependent dies or in some other fashion ceases to satisfy the eligibility requirements for coverage, as an example, then the election by the employee to cancel health insurance for any other dependent, for himself or his spouse, does not correspond to the change in status.
There is an exception to the consistency rule in those cases where an employee, spouse or dependent becomes eligible for COBRA continuation coverage, the plan may allow the employee to elect to increase payments under the plan to pay for the COBRA coverage.
For group term life insurance and disability coverage, an election under a Cafeteria Plan to increase (or decrease) coverage because of the change in status outlined above, is considered as corresponding to that change in status.194
The consistency rule is considered to have been satisfied if an election change is because of and corresponds to a change in status that affects the employees' eligibility for coverage under the plan. The election change also meets the consistency rule if it is because of and corresponds with a change in status affecting dependent care expenses, or adoption assistance expenses.195
(It should be noted that the rules regarding election changes because of significant cost or change of coverage apply to all kinds of qualified benefits under a Cafeteria Plan, but not to health flexible spending arrangements [FSAs]).
If the cost of a qualified benefits plan increases or decreases during a period of coverage, the plan may automatically make a "prospective" (not retrospective) change in the salary reduction amount of the employee.196 If the cost of a benefit plan option significantly increases during the coverage period, the plan may allow the employees to either increase their salary reduction amounts, or to revoke their election for that particular benefit and elect another benefit option that offers similar coverage on prospective basis.197 Conversely, if the cost of the qualified benefits significantly decreases during the year, the plan may allow all employees (even if they had not previously participated in the plan) to elect to participate in the plan for the particular option that has decreased in cost.198
If the employee has a significant loss of coverage under a plan during the coverage period that is, in effect, a loss of coverage, then the plan may allow the employee to revoke his previous election and elect to receive (prospectively) another option that provides similar coverage. If there is no similar coverage available, the employee may drop the coverage. A "loss of coverage" occurs when there is a complete loss of coverage caused by such as elimination of an option, an HMO ceasing to operate in the area, or losing all coverage because of an overall lifetime or annual limitation.199
If an employee suffers from a significant loss of cover, such as a significant increase in the deductible, or the copayment, or out-of-pocket expense, the plan may allow the employee to revoke his election and elect to receive (prospectively) coverage under another option that provides a similar coverage.200
If, on the other hand, the plan adds a new benefit option or improves an existing benefit package option or other coverage option, during a period of coverage, then the plan can allow eligible employees—even if they had not previous elected to make an option under the Cafeteria Plan—to revoke their election and to make a new election (prospectively) for coverage under the new and/or improved option.201
If an employee loses coverage under a governmental or educational institution group health plan, then a Cafeteria Plan may allow an employee to make a (prospective) election change that would correspond to a change made by another employer plan or to add coverage under the plan.202
The plan may allow an employee to make a prospective election change that corresponds to a change made under another employer plan or to add coverage under a plan for the employee/spouse/dependent if the employee/spouse/dependent loses coverage under any group health plan sponsored by a government or educational institution.203
After consideration, in 2001 the final regulations state that employers may require the employees to continue coverage if the employer pays the employee's portion of the coverage cost.204 Further, employers on FLMA leave usually are allowed to revoke or change elections in the same manner as those employees not on FLMA leave, but they are entitled to be reinstated if their coverage terminated during their leave, either by revocation or nonpayment of premiums.205
The same general rules apply to an health flexible spending arrangement as traditional Cafeteria Plans, including the right of an employee on a FLMA leave to be reinstated.
As long as the employee's coverage under the Health FSA is continued, the entire amount of his FSA, less any previous reimbursements, must be available for reimbursement of his health expenses. If the coverage is terminated at any time during the FLMA leave, the employee is not entitled to reimbursement for expenses incurred while the coverage was terminated.206
A Cafeteria Plan usually offers employees on unpaid FMLA leave up to three options for paying for their health coverage under a Cafeteria Plan or Health FSA, and any of the options can be made on a pre-tax salary reduction basis, to the extent that the employee on FLMA leave spans two plan years. These three options may also be made on an after-tax basis:
Also, Health FSAs are usually subject to the same payment rules as traditional Cafeteria Plans.
Note: Under the regulations, employers are not required to continue an employee's non-health benefits provided under a Cafeteria Plan—such as life insurance—during an FMLA leave, but the employee is entitled to continuing non-health benefits on the same basis as employees not on FMLA leave.207
Since amounts that are received by cafeteria-plan participants or their beneficiaries are not considered as wages, these amounts are not subject to Social Security or Federal Unemployment taxes if these payments would not be treated as wages without regard to the plan.208
Note: In previous years, the employer that sponsors a Cafeteria Plan must file an information return with the IRS, indicating the number of employees, the number of employees eligible for participation in the plan, the number actually participating, cost of the plan, etc. However, the IRS has recently suspended these reporting requirements, with further guidelines from the IRS to be provided in the unspecified future.
A flexible spending arrangement (FSA) is another program regulated by IRC Section 125 that allows for reimbursement of specified, incurred expenses. This arrangement may be a stand-alone plan or part of a Cafeteria Plan—the most well-known are Health FSAs and dependent care assistance FSAs. In order for the FSA coverage to qualify for the exclusion from income, there are certain requirements that must be met.
The FSA health coverage does not need to be provided by an insurance plan, but it must have the risk shifting and risk distribution characteristics of insurance, particularly an indemnity plan as it must be paid specifically for the reimbursement of previously-incurred medical expenses. In fact, a Health FSA is not allowed to provide coverage only for periods when the participants expect to incur medical expenses, if the period is less than a plan year.209 Also, in keeping with the "insurance" philosophy, the maximum amount that may be reimbursed must always be available during the coverage period—except that it can be reduced for prior reimbursements covering the same period of time. Unlike insurance, the maximum amount of reimbursement must be available irregardless as to whether the participant has paid the required premium for the coverage period, plus, there must not be a premium payment schedule based on the rate or amount of claims incurred during the coverage period.210
The period of coverage must always be 12 months, of the entire first year in case of a short first-plan year. Election changes cannot be permitted to increase or decrease coverage during a coverage, but a.s prospective change may be allowed consistent with certain family status changes. The plan may be terminated if the employee does not pay due premiums, but only if the plan terms prohibit the employee from making a new election during the remaining coverage period. The plan is allowed to allow a terminated employee to revoke existing elections.
As with other cafeteria provisions, there may be a grace period of no more than 2 ½ months following end of the plan year for participants to incur and submit expenses for all reimbursement.
Medical expenses reimbursement may be provided but
Fit may not reimburse for premiums paid for other health plan coverage.211
The plan may reimburse for non-prescription over-the-counter drugs. Employer-provided coverage for qualified long-term care services under an FSA is included in the employee's gross income.
As an interesting note, the IRS has approved the use of employer-issued debit and credit cards to pay for medical expenses as incurred, provided that the employer has the means and procedures in place to substantiate the payments.
The rules for dependent care assistance FSAs are the basically the same as to Health FSAs, except that the maximum amount of reimbursement need not be available throughout the coverage period and the plan can limit the participant's reimbursement to the amounts actually contributed to the plan that is still in the account. The grace period is the same as for the Health FSAs. In any event, contributions to a dependent care FSA may not exceed $5,000 during any taxable year.212
Certain qualified employees may claim a dependent care tax credit on their personal income tax filing, with $3,000 of employment-related child care expenses for one dependent, or $6,000 for two or more dependents. This will save the taxpayer—depending upon his income—anywhere from 20% to 35%. An employee who has two or more qualified dependents who has $6,000 of eligible expenses—and who has received the maximum of Dependent Care Assistance Plan (DCAP) of $5,000—may be eligible to claim a percentage of the $1,000 difference. Note, however, employees may not claim the same expense under both the tax credit and the DCAP!
Since this can mean considerable savings to the lower-income worker who probably needs all the help they can get, the professional representative should always make a decided effort to ensure that employees understand the differences between the tax credit and the DCAP.
Any experience gain or income of an FSA can be used to reduce premium for the following year, or returned to the premium payors as dividends or premium refunds, but they may not be based upon individual claims experience.
The maximum reimbursement amount for a coverage period may not be "substantially" in excess of the total cost ("premium") for the coverage; "substantially" is where the excess of the total premium of the maximum amount is less than 500% of the premium.213
The IRS has provided non-binding guidance in respect to FSAs that indicate that orthodontia expenses should be treated differently from other medical expenses, and if orthodontia expenses are paid by a lump sum when the orthodontia work commences (instead of being paid over the course of the treatment), they may be reimbursed under an FSA when they are paid.
Further, the IRS has informally ruled that there is no minimum claim amount that need not be substantiated, which means that employers and plan administrators must substantiate all claims, even small ones.
The insurance companies that market Cafeteria Plans provide various degrees of administrative assistance and they provide their representatives with documentation as to the various plans available. They also provide extensive training including in-depth instruction in federal and state regulations that apply.
Basically, as stated earlier, a Cafeteria Plan must be a separate written document (insurers usually furnish sample plan documents) which must be submitted by the employer. All employees must be informed and usually representatives will inform the employees as to how the plan works and the advantages to them—either in group meetings or on an individual basis, or both.
The plan must offer taxable or qualified nontaxable benefits, and the tax status should be understood by all employees offered the plan.
Plan documents and employee salary deduction forms must be formally executed before the plan becomes effective. Insurance company representatives normally are responsible for the proper documentation (forms usually furnished by the insurer) and for the enrollment.
The documentation for a Cafeteria Plan consists of a sample plan document, an acceptance (acknowledgement) form signed by the employer, and a Summary Plan document (which must be distributed to ALL employees within 120 days of the plan effective date and made available by the employer to all new hires or plan participants). If there is a Flexible Savings Plan (FSA) involved, a separate agreement is required (called, for instance, "Reimbursement Services Agreement")
In addition to these general documents, the documents must provide the following information to the employer and the employees:
FAll eligible employees must be enrolled prior to the plan effective date & all insurance policies must be effective on the effective date of the plan. New employees must be enrolled prior to the end of the eligibility period & the plan must then be effective on date of eligibility.
During the initial election period, those employees who did not elect to participate in the Cafeteria Plan will not be able to participate until the next annual election period, except if there is a qualified change in status.
The first pre-tax premium deduction cannot occur until after the effective date of the plan. For those plans that require underwriting, pre-tax premiums should not be taken until the application has been approved.
There is generally an open enrollment period prior to the anniversary date of the plan, at which time each participant has the opportunity to make changes or revoke elections for the next plan year.
For years, the employer was required to file an information form—Form 5500— with the IRS and with the Department of Labor. In 2002, the IRS suspended the filing requirement if the filing would report information only on a Cafeteria Plan, and educational assistance, or an adoption assistance program. However, this does not affect the Department of Labor requirements so accident, health and welfare benefit plans must still file a Form 5500 (and any other required forms).
Benefit plans that are subject to Title I of ERISA and are associated with fringe benefit plans, must continue to file Form 5500. Further information on the filing of this form is provided to the field representatives by the insurance company, or it may be obtained at www.irs.gov/ep with reference to "Topics" and "EP Forms & Publications."
Insurers who are in the group insurance, employee benefit, and/or Cafeteria Plan market have their forms for the various installation steps based upon their area of interest, state regulations, and administrative requirements. Insurance representatives and sales persons who are involved in the employee benefit area must be well educated in the enrolling requirements of the insurer and more detailed discussion of this would be outside of the scope of this text.
STUDY QUESTIONS
1. Cafeteria Plans are particularly attractive in
A. the field of payroll deduction employee benefits.
B. corporations as the employers pay for all of the Cafeteria Plan benefits.
C. self-employed small firm owners.
D. the long term disability insurance market.
2. The key to the success of the Cafeteria Plans is that participating employees may redirect a portion of their salaries for the purchase of qualified benefits
A. by after-tax salary deductions.
B. by pre-tax salary deductions.
C. which are always paid by the employer.
D. and where neither the employee nor the employer ever pay taxes on the contributions.
3. An insurance salesperson will be considered as an employee for Cafeteria Plan purposes
A. in any event.
B. if he has been a licensed insurance agent for a period of at least 10 years.
C. if treated as an employee for Social Security purposes.
D. only after retirement.
4. Contributions that are used to provide coverage for a non-dependent domestic partner
A. are treated as taxable income.
B. 50% of the employee contribution is taxable to the domestic partner.
C. will cause all contributions to Cafeteria Plan benefits to be taxable as ordinary income.
D. must be paid from the employer's business account used for employee benefits.
5. There are three sub-types of plans offered under Section 125:
A. the A, B, and C plans.
B. the qualified, non-qualified and the intermediate plans.
C. the employer paid, employee paid, and trust paid plans.
D. the premium only, unreimbursed medical and the dependent care plans.
6. Joe has an unreimbursed medical account with an annual maximum of $5,000. In 2003, he used $4,000, in 2004, he used $3,000, how much was in his account as of 1/1/2005?
A. $8,000.
B. $3,000.
C. $7,000.
D. $5,000.
7. A separate written plan of an employer for the exclusive purpose of providing employees with payment for or the provision of services, which, if paid for the employee, would be considered as employment-related expenses. This would be
A. a dependent care assistance program.
B. an HSA.
C. an MSA.
D. a short term disability program.
8. Life, health, disability or long-term care insurance with an investment feature
A. cannot be purchased under a Cafeteria Plan.
B. can be purchased under a Cafeteria Plan only if the employee pays all the premium.
C. and cancer or other specific disease policies cannot be purchased under a Cafeteria Plan.
D. that provides benefits to retired employees, the contributions are never tax deductible to
either the employee or the employer.
9. If disability insurance is sold with a pre-tax premium
A. benefits must be payable only for total disability or any contribution from either the em-
ployer or the employee will be taxable in the year when the contribution is paid
B. any disability claim payments will show on the employee's W-2 as nontaxable income.
C. the employee will be subject to income taxes on the benefits received during the duration
of the disability.
D. 25% of the pre-tax premium is taxable to the employee in the year of election.
10. Medical expenses under a Cafeteria Plan may be provided
A. but it may not reimburse for premiums paid for other health coverage.
B. only to key employees and highly compensated personnel.
C. for the purpose of reimbursing the employee for premiums for medical insurance.
D. for the employee, provided the employer pays the entire premium.
ANSWERS TO STUDY QUESTIONS
1A 2B 3C 4A 5D 6D 7A 8A 9C 10A