Section 125 of the Internal Revenue Code created cafeteria plans, which enable employers to offer their employees a choice between taxable and qualified non-taxable benefits. There are several IRS tax codes and regulations that must be followed when an employer offers a cafeteria plan to its employees in order to preserve non-taxable benefits.
Basic Cafeteria Plan Requirements
- A cafeteria plan must be in writing, so a plan document is necessary.
- The plan must be established by the employer for the benefit of employees. Non-employees, such as partners and 2% or more shareholders in an S-Corporation, may not participate.
- It must offer participants the choice between taxable and qualified non-taxable benefits.
- There must be a designated plan year of 12 months. A shorter plan year is only permissible for valid business reasons.
- Employees make an annual election for benefits that cannot be changed until the next plan year, unless the plan permits a mid-year election change consistent with IRS Regulations § 1.125-4 (Permitted Election Changes).
- Eligibility, benefits, and contributions cannot favor key or highly compensated employees. Nondiscrimination testing is required.
- Underlying ERISA benefits, such as group health or welfare coverage, including a health care flexible spending account (FSA), are subject to DOL reporting and disclosure requirements. The cafeteria plan itself is not considered an ERISA plan or subject to DOL reporting and disclosure requirements.
- Coverage under a health plan, including medical, prescription drug, vision, and dental plans, such as through a premium conversion arrangement
- Health flexible spending accounts (health FSA)
- Dependent care assistance programs (DCAP or dependent care FSA)
- Group term life insurance coverage (however, the value of coverage over $50,000 is taxable income to the employee)
- Disability insurance (deducting premium pre-tax will result in taxable disability benefits)
- Adoption assistance programs
- Health savings accounts (HSAs) contributions
Under premium conversion (or salary reduction), the employee’s share of the cost for group health and other welfare plan coverage is deducted on a pre-tax basis from pay. This means employees do not pay income or payroll taxes on their share of the cost for coverage, and employers also save on payroll taxes.
Flexible Spending Accounts (FSAs)
A health FSA allows employees to set aside part of their salary on a pre-tax basis for unreimbursed medical expenses. When eligible expenses are incurred during the plan year, participating employees file claim forms or use a debit card to be reimbursed from their accounts on a tax-free basis. Health FSAs are subject to the uniform coverage rule, which means the annual election is available anytime during the plan year. Employers set the maximum employee election amount, up to a limit of $2,700 (2019 plan year limit) in a plan year. Employers can also contribute towards the health FSA, but if the employer contribution is more than $500 per year, the health FSA is no longer considered an “excepted benefit” and becomes subject to other rules.
A dependent care FSA allows employees to set aside part of their salary on a pre-tax basis for work-related day care expenses. The rules for eligible dependents and expenses follow the same rules the IRS has set for the child and dependent care tax credit described in IRS Publication 502. Dependent care FSA elections are limited to $5,000 ($2,500 if married filing separately) in a calendar year for both employee and employer contributions.
Both FSAs are subject to “use or lose” rules requiring that any unused balance in an FSA at the end of a plan year is forfeited by the employee. Unused balances cannot be returned to the employee or rolled over into a new plan year unless the employer adopts either a grace period or the carryover provision explained below.
At the employer’s option, the cafeteria plan may have a 2.5 month extension to the 12 month plan year, called a grace period. This grace period allows participants to continue incurring health or dependent care FSA claims for an election made during the regular 12 month plan year. The plan document must be amended to include the grace period and the employer should understand the administrative implications.
Alternatively, the employer could choose to adopt a carryover provision. The IRS introduced a carryover in 2013 permitting cafeteria plans to be amended to allow participants to carryover up to $500 of unused health FSA funds to be applied to qualified medical expenses in the following year. Funds that are carried over do not reduce the maximum election limits. Participants with carryover funds cannot contribute to an HSA unless their funds are carried over to a limited use FSA.
The employer may not adopt both the grace period and carryover for the health FSA the same plan year.
A cafeteria plan can allow employees to make pre-tax contributions into their HSAs. Unlike other cafeteria plan elections, employees can change their HSA pre-tax contribution during the plan year without a permitted election change described in IRS Regulations § 1.125-4.
If employer contributions into HSAs are included in the cafeteria plan, the HSA comparability rules do not apply. However, all contributions into HSAs are included in cafeteria plan nondiscrimination testing, so it can be difficult for employers to contribute more to key or highly-compensated employees.