In the near future, failure to comply with
Internal Revenue Service regulations that
were proposed last summer could result in significant tax problems for employers
and employees. These regulations would
have a profound impact on the cafeteria
benefit programs of most employers, covered under IRS Code Section 125.
“While the previous regulations were
unclear, outdated and generally not enforced, the new proposed regulations are
very specific and would provide the IRS
with powerful enforcement tools,” says Kurt
Smidansky, a partner at Jackson Lewis LLP.
“In certain respects, the proposed rules
are even more stringent than the rules applicable to 401(k) and other qualified retirement plans,” adds Jason Rothman, an associate at Jackson Lewis specializing in work-place law.
The IRS will issue final regulations sometime in the future, which may or may not
relax some of the proposed requirements,
including the possible extension of the
effective date (Jan. 1, 2009). Still, employers
need to consider the effects of the proposed regulations on their cafeteria plans
based on the current requirements and
effective date.
Smart Business talked to both Rothman
and Smidansky about some of the key issues
employers need to address in their cafeteria
plan documentation and operation.
Why use the term ‘cafeteria’ when referring to
Section 125?
Generally, a cafeteria plan is a tax code
vehicle that allows employees to elect to
have salary contributed on a pretax basis
toward certain employer-provided welfare
benefits. The plan contains options from
which employees can pick and choose —
similar to going through a cafeteria line. The
idea for the name of the code section stems
from employees having a menu of choices.
For example, pretax employee contributions toward medical coverage, including
flexible spending arrangements, group-term
life insurance, dependent care assistance
programs and adoption assistance programs, are required to be made under a cafeteria plan in order to qualify for the pretax
treatment.
How would the proposed regulations affect
cafeteria plans?
They contain very explicit and detailed
requirements as to what must be included in
the written cafeteria plan document:
- A description of all benefits under the
plan - The rules for eligibility to participate,
specifically requiring that all participants be
employees - The procedure governing employee
elections and that all elections are irrevocable — subject to certain exceptions for a
change in status - How employer contributions are made
to the cafeteria plan and the maximum
amount of elective contributions - The plan year
- The use-it-or-lose-it and uniform coverage rules — if the cafeteria plan contains a
flexible spending arrangement - Grace period requirements, if applicable
The proposed rules also appear to require
plan amendments to be adopted prior to the
date they are effective, meaning plan changes
will need to be documented before implementation. The regulations also provide guidance on cafeteria plan nondiscrimination
rules that would make them more enforceable. One troublesome aspect requires testing to be done at the end of the year, with no
ability to go back and fix problems that might
have created a failed test. Testing would be
the responsibility of the employer.
Why should employers be concerned with
these regulations?
Even one minor failure to satisfy Code
Section 125 would trigger disqualification of
the entire arrangement, thereby re-characterizing salary contributions under the plan as
made on an after-tax — rather than pretax —
basis. In addition, not having the ability to fix
problems would place a heavy burden on
employers to structure programs that are
predesigned to comply with all of the rules.
Wouldn’t the regulations unfairly penalize
employees, who have no hand in compliance, rather than employers?
The IRS’s proposal is harsh. The employer
would be affected by losing a lot of credibility in the eyes of the employees, plus it
would have a withholding mess on its hands.
But the real sting is on the employees, who
would not receive a favorable tax treatment
if their company’s plan were disqualified.
What must employers do?
They need to review and analyze their
cafeteria plans to determine the impact of
the new proposed regulations. Attention to
the actual plan document is a must, as the
failure to have a properly drafted plan
would disqualify the plan. Employers who
sponsor cafeteria plans also need to check
how their plans will likely perform under
the year-end nondiscrimination testing to
make sure they comply with the new
requirements. Additionally, cafeteria plans
with a flexible spending arrangement would
have to deal with several additional requirements. Because disqualification would result in taxation to employees of all benefits
provided under the cafeteria plan, it is in the
best interest of an employer and its employees to take action prior to Dec. 31, 2008.
JASON ROTHMAN is an associate at Jackson Lewis LLP, where he represents management in workplace law and related litigation.
Reach him at (216) 750-0418 or [email protected]. KURT SMIDANSKY is a partner at Jackson Lewis LLP. Reach him
at (216) 750-0404 or [email protected].
