Proposed Regulations Issued for Cafeteria Plans

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On August 3, 2006, the U.S. Treasury Department and the Internal Revenue Service (IRS) released proposed regulations regarding cafeteria plans. These rules replace the previously-proposed and temporary regulations issued intermittently between May 1984 and March 2000. The newly-proposed regulations primarily reinforce previous regulations and guidance such as Revenue Rulings and IRS Notices, and also include some new provisions. The proposed effective date for these regulations is January 1, 2009. Until final regulations are issued, the proposed regulations may be relied upon for guidance. A copy of the proposed regulations and instructions for submitting comments are available at: http://www.ustreas.gov/press/releases/reports/section125.pdf

Highlights of the Proposed Legislation

  • A cafeteria plan is the only tax-advantaged method in which an employer can offer its employees a choice between taxable and nontaxable benefits.  If the choice is given outside of a cafeteria plan, the amount of the taxable benefits is included in employee gross income regardless of the option selected.
  • A health flexible spending arrangement (FSA) may choose to reimburse participants for orthodontic expenses before the orthodontic services have been performed, if the employee pre-paid  the expenses in order to receive the services.
  • Premiums for individual accident and health insurance are permitted to be reimbursed or paid through a cafeteria plan as long as the expense is substantiated.
  • COBRA premiums for the continuation of the employer's coverage -- or a former employer's coverage -- may be paid though a cafeteria plan.
  • Only employees may participate in a cafeteria plan.  The term "employee" includes common-law and leased employees, but does not include sole proprietors, partners, or 2% shareholder of S corporations.
  • All requests for reimbursement under an FSA must be substantiated before being paid or reimbursed.  The practice of substantiating only a certain number or percentage of claims, or only substantiating claims above a certain dollar amount, do not meet the substantiation requirement.
  • An employer will have the option to reimburse a terminated employee for dependent care expenses that are incurred after the employee's termination date.
  • If an employee is provided with group term life insurance in the excess of $50,000, any contributions through the cafeteria plan for the life insurance will be excluded from taxation.  Then employee will continue to be taxed on the cost of the coverage that exceeds $50,000 (based on the IRS Table 1 rates), minus any after-tax contribution made by the employee.

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