The Internal Revenue Service has withdrawn several sets of proposed and temporary regulations under Section 125 of the Tax Code (some dating back to 1984) and then reproposed those regulations in a substantially reorganized format. Though the substantive changes made by these regulations are few, the comprehensive nature of the regulations will make them of great interest to sponsors and administrators of cafeteria plans.
The IRS anticipates that these regulations will be finalized in time to apply to plan years beginning on or after January 1, 2009. In the meantime, sponsors and administrators of cafeteria plans may already rely on these proposed regulations. And, frankly, on most of the issues arising under Section 125, these are all the guidance we have.
Sole Exception to “Constructive Receipt” Doctrine
The IRS emphasizes in these regulations that the only way employees may be allowed to elect among taxable and nontaxable benefits — without implicating the “constructive receipt” doctrine — is by offering that election through a cafeteria plan. Such a plan must comply with the various requirements spelled out in these proposed regulations. These include limits on the types of “qualified benefits” that may be offered under the plan, constraints on mid-year election changes, substantiation requirements, the “uniform coverage” and “use-or-lose-it” rules (applicable to certain flexible spending arrangements), and limitations on the use of experience gains (or forfeitures) arising under the plan.
Employers may want to take this opportunity to consider whether they are offering their employees a choice between taxable and nontaxable benefits outside of a cafeteria plan. If so, they should either move that choice into a cafeteria plan (if possible) or eliminate it altogether. “Nonqualified Benefits”
These regulations also itemize various types of “nonqualified benefits” — the offering of which through a cafeteria plan will undermine the protection from constructive receipt otherwise afforded under Section 125. These nonqualified benefits include educational assistance (under Section 127), life insurance on an employee’s dependents, and elective deferrals to a Section 403(b) plan (although elective deferrals to a 401(k) plan may continue to be offered through a cafeteria plan).
Moreover, neither long-term care insurance premiums nor long-term care expenses may be paid through a cafeteria plan — unless those premiums or expenses are paid through a health savings account (“HSA”) that is itself funded through the cafeteria plan. Again, employers may want to consider whether their cafeteria plans offer any of these nonqualified benefits.
Taxation of Group-Term Life Insurance Coverage
Finally, these proposed regulations make a welcome change in the rules that apply when calculating an employee’s taxable income attributable to the cost of group-term life insurance coverage in excess of $50,000 provided through a cafeteria plan. Under IRS Notice 89-110, an employee was taxed on the greater of the cost of that insurance (as determined using the Table I rates in the Section 79 regulations) or the amount of salary reduction and employer contributions applied to the payment of premiums for that coverage.
Under these proposed regulations, any salary reduction and employer contributions applied to the purchase of group-term life insurance coverage are excludable from an employee’s gross income. Thus, the employee will be taxed on only the Table I cost of the insurance coverage in excess of $50,000. The IRS specifically notes that employers may immediately rely on this aspect of the proposed regulations when calculating their employees’ taxable income.