Clamping down Featured

8:00pm EDT March 26, 2008

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“While the previous regulations were unclear, outdated and generally not enforced, the new proposed regulations are very specific and would provide the IRS with powerful enforcement tools,” says Kurt Smidansky, a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 jason.rothman@jacksonlewis.com. KURT SMIDANSKY is a partner at Jackson Lewis LLP. Reach him at (216) 750-0404 or smidanskyk@jacksonlewis.com.