Tax Treatment of Cafeteria Plans

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8738]

RIN 1545-AV43

Tax Treatment of Cafeteria Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Temporary regulations.

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SUMMARY: This document contains temporary regulations that clarify the

circumstances under which an employer may permit a cafeteria plan

participant to revoke an existing election and make a new election

during a period of coverage. The text of these temporary regulations

also serves as the text of the proposed regulations set forth in the

notice of proposed rulemaking on this subject in the proposed rules

section of this issue of the Federal Register.

DATES: These regulations are effective on December 31, 1998.

FOR FURTHER INFORMATION CONTACT: Sharon Cohen, (202) 622-6080 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26

CFR part 1) under section 125. These temporary regulations provide

guidance relating to the circumstances under which a cafeteria plan

participant may revoke an existing election and make a new election

during a period of coverage.

Explanation of Provisions

A ``cafeteria plan'' under section 125 allows an employee to choose

between cash and certain nontaxable benefits, such as accident or

health coverage. Section 125 generally permits the employee to choose

the nontaxable benefit (rather than the available cash) without the

employee having to include the available cash in gross income. The

temporary regulations:

Permit a cafeteria plan to allow an employee, during a

plan year, to change his or her health coverage election to conform

with the new special enrollment rights provided under the Health

Insurance Portability and Accountability Act of 1996 (HIPAA), and

Permit a cafeteria plan to allow a change in coverage

election for a variety of other changes in status.

These regulations are designed to provide clear, administrable

guidelines for determining when changes can be made in cafeteria plan

elections during a plan year.

These regulations are effective for plan years beginning after

December 31, 1998. However, taxpayers may rely on the guidance in the

temporary regulations (or on the existing proposed regulations) for

prior periods.

Summary

Section 125 generally provides that an employee in a cafeteria plan

will not have an amount included in gross income solely because the

employee may choose among two or more benefits consisting of cash and

``qualified benefits.'' A qualified benefit generally is any benefit

that is excludable from gross income because of an express provision of

the Code, including coverage under an employer-provided accident or

health plan under sections 105 and 106, group-term life insurance under

section 79, elective contributions under a qualified cash or deferred

arrangement within the meaning of section 401(k), dependent care

assistance under section 129, and adoption assistance under section

137.\1\ Under Secs. 1.125-1 and 1.125-2 of the existing proposed

regulations,\2\ an employee is permitted to make an election between

cash and qualified benefits before the beginning of the period of

coverage (which generally is the plan year of the cafeteria plan);

changes in the election during the plan year are permitted only in

limited circumstances.

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\1\ The following are not qualified benefits: products

advertised, marketed, or offered as long-term care insurance;

medical savings accounts under section 106(b); qualified

scholarships under section 117; educational assistance programs

under seciton 127; and fringe benefits under section 132.

\2\ Published as proposed rules at 49 FR 19321 (May 7, 1984) and

54 FR 9460 (March 7, 1989), respectively.

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The temporary regulations clarify the circumstances under which a

cafeteria plan may permit an employee to change his or her cafeteria

plan election with respect to accident or health coverage or group-term

life insurance coverage during the plan year. Proposed regulations are

also being published that cross-reference these temporary regulations,

and that replace the change in family status provisions in Q&A-6 of

proposed Sec. 1.125-2 with respect to accident or health plans and

group-term life insurance.

HIPAA Special Enrollment Rules

The temporary regulations conform the cafeteria plan rules to the

new special enrollment rights provided under HIPAA (which generally

require group health plans to permit individuals to be enrolled for

coverage following the loss of other health coverage, or if a person

becomes the spouse or dependent of an employee through birth, marriage,

adoption, or placement for adoption).\3\ Under the regulations, if an

employee has a right to enroll in an employer's group health plan or to

add coverage for a family member under HIPAA, the employee can make a

conforming election under the cafeteria plan. This allows required

contributions for such health coverage to be paid on a pre-tax basis.

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\3\ See section 9801(f). Similar provisions are set forth in

section 701(f) of the Employee Retirement Income Security Act of

1974 (ERISA), and section 2701(f) of the Public Health Service Act.

Regulations under these provisions are set forth in Treas. Reg.

Sec. 54.9801-6T; 29 C.F.R. Sec. 2590.701-6; and 45 C.F.R.

Sec. 146.117.

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Changes in Status

The temporary regulations include rules for other events, called

``changes in status,'' under which a cafeteria plan may allow an

employee to change his or

[[Page 60166]]

her election during the plan year. The events that constitute changes

in status under the regulations are changes in legal marital status,

number of dependents, employment status, work schedule, and residence

or worksite, and cases where the dependent satisfies or ceases to

satisfy the requirements for unmarried dependents.

The regulations permit a cafeteria plan to allow a change of

election during the plan year if a change in status occurs that affects

eligibility for coverage and the election change corresponds with the

effect on eligibility. For example, if under the terms of an accident

or health plan a child of an employee loses eligibility for coverage

upon graduation from college, the cafeteria plan may allow the employee

to cease payment for the child's coverage when the child graduates and

coverage ceases.

Certain of these changes in status (marriage, birth, adoption, and

placement for adoption) overlap with the special enrollment events

under HIPAA. The regulations include examples that clarify the

relationship between HIPAA's special enrollment rights and these change

in status rules. In addition, if a change in status occurs that

entitles an employee or family member to ``COBRA'' continuation

coverage (or coverage under a similar State program) with respect to

the employer's plan, the regulations permit payments for the

continuation coverage to be made on a pre-tax basis under a cafeteria

plan.

Other Events

The regulations allow a corresponding cafeteria plan change if a

plan receives a court order, such as a qualified medical child support

order under section 609 of ERISA. In addition, if an employee, spouse,

or dependent becomes entitled to Medicare or Medicaid, a cafeteria plan

can permit a corresponding election change.

Elective Contributions Under a Qualified Cash or Deferred Arrangement

The temporary regulations, in provisions similar to those of the

existing proposed regulations (proposed Sec. 1.125-2(f)), make clear

that the rules of section 401(k) and (m), rather than the rules in

these temporary regulations (which apply to other qualified benefits),

govern changes in elections under a qualified cash or deferred

arrangement (within the meaning of section 401(k)) or with respect to

employee after-tax contributions subject to section 401(m).

Scope of Temporary Regulations and Reliance on Proposed Regulations

The temporary regulations do not address certain provisions

concerning cafeteria plan election changes that are included in the

existing proposed regulations. Guidance on these provisions is reserved

at paragraphs (f)-(i) of the temporary regulations.

For example, future guidance under the significant cost change

provision (reserved at paragraph (g) of the temporary regulations),

rather than the change in status rules, would determine whether an

employee who switches from full-time to part-time employment and who

remains eligible under the employer's health plan could make an

election change if the part-time employee is required to pay

significantly higher amounts for the coverage. The temporary

regulations also reserve guidance with respect to provisions set forth

in the existing proposed regulations that permit an election change in

the case of a significant change in coverage (which includes a

significant change in the health coverage of the employee or spouse

attributable to the spouse's employment).\4\ Other matters not

addressed in the temporary regulations include the application of the

cafeteria plan election change rules to qualified benefits other than

accident or health coverage and group-term life insurance coverage (for

example, dependent care assistance programs), and special rules

concerning changes in elections by employees taking leave under the

Family and Medical Leave Act of 1993 (Pub. L. 103-3).\5\ Pending

further guidance, taxpayers can continue to rely on the existing

proposed regulations \6\ concerning these and other matters not

addressed in the temporary regulations.\7\

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\4\ See the second-to-last sentence in Q&A-6(c) of proposed

Sec. 1.125-2.

\5\ See Sec. 1.125.3, published as a proposed rule at 60 FR

66229 (December 21, 1995).

\6\ See also Sec. 1.125-2T, published at 51 FR 4312 (January 29,

1986), which describes benefits that may be offered under a

cafeteria plan.

\7\ See the preambles to proposed Secs. 1.125-1 and 1.125-2 and

Q&A-8 of proposed Sec. 1.125-3.

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The temporary regulations are effective for plan years beginning

after December 31, 1998. Prior to that date, however, taxpayers can

rely on the guidance provided in the temporary regulations (as well as

on the guidance provided in the existing proposed regulations that

relates to matters addressed in the temporary regulations) in order to

comply with the provisions of section 125.

Special Analyses

It has been determined that this Treasury Decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It also has been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

does not apply to these regulations, and because the regulation does

not impose a collection of information on small entities, the

Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply.

Pursuant to section 7805(f) of the Internal Revenue Code, these

temporary regulations will be submitted to the Chief Counsel for

Advocacy of the Small Business Administration for comment on its impact

on small business.

Drafting Information

The principal authors of these regulations are Catherine Fuller and

Sharon Cohen, Office of the Associate Chief Counsel (Employee Benefits

and Exempt Organizations). However, other personnel from the IRS and

Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority for part 1 continues to read in part as

follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Sec. 1.125-4T is added to read as follows:

Sec. 1.125-4T Permitted election changes (temporary).

(a) Election changes. A cafeteria plan may permit an employee to

revoke an election during a period of coverage and to make a new

election only as provided in paragraphs (b) through (i) of this

section. See paragraph (j) of this section for special provisions

relating to qualified cash or deferred arrangements.

(b) Special enrollment rights. A cafeteria plan may permit an

employee to revoke an election for accident or health coverage during a

period of coverage and make a new election that corresponds with the

special enrollment rights provided in section 9801(f), whether or not

the change in election is permitted under paragraph (c) of this

section.

[[Page 60167]]

(c) Changes in status for accident or health coverage and group-

term life. (1) In general. A cafeteria plan may permit an employee to

revoke an election for accident or health coverage or group-term life

insurance coverage during a period of coverage and make a new election

for the remaining portion of the period if, under the facts and

circumstances --

(i) A change in status occurs; and

(ii) The election change satisfies the consistency requirement in

paragraph (c)(3) of this section (consistency rule for accident or

health coverage) or (c)(4) of this section (consistency rule for group-

term life insurance coverage).

(2) Change in status events. The following events are changes in

status for purposes of this paragraph (c):

(i) Legal marital status. Events that change an employee's legal

marital status, including marriage, death of spouse, divorce, legal

separation, or annulment;

(ii) Number of dependents. Events that change an employee's number

of dependents (as defined in section 152), including birth, adoption,

placement for adoption (as defined in regulations under section 9801),

or death of a dependent;

(iii) Employment status. A termination or commencement of

employment by the employee, spouse, or dependent;

(iv) Work schedule. A reduction or increase in hours of employment

by the employee, spouse, or dependent, including a switch between part-

time and full-time, a strike or lockout, or commencement or return from

an unpaid leave of absence;

(v) Dependent satisfies or ceases to satisfy the requirements for

unmarried dependents. An event that causes an employee's dependent to

satisfy or cease to satisfy the requirements for coverage due to

attainment of age, student status, or any similar circumstance as

provided in the accident or health plan under which the employee

receives coverage; and

(vi) Residence or Worksite. A change in the place of residence or

work of the employee, spouse, or dependent.

(3) Consistency rule for accident or health coverage. (i) General

rule. (A) An employee's revocation of a cafeteria plan election during

a period of coverage and new election for the remaining portion of the

period (referred to below as an ``election change'') is consistent with

a change in status if, and only if--

(1) The change in status results in the employee, spouse, or

dependent gaining or losing eligibility for accident or health coverage

under either the cafeteria plan or an accident or health plan of the

spouse's or dependent's employer; and

(2) The election change corresponds with that gain or loss of

coverage.

(B) A change in status results in an employee, spouse, or dependent

gaining (or losing) eligibility for coverage under a plan only if the

individual becomes eligible (or ineligible) to participate in the plan.

A cafeteria plan may treat an individual as gaining (or losing)

eligibility for coverage if the individual becomes eligible (or

ineligible) for a particular benefit package option under a plan (e.g.,

a change in status results in an individual becoming eligible for a

managed care option or an indemnity option). If, as a result of a

change in status, the individual gains eligibility for elective

coverage under a plan of the spouse's or dependent's employer, the

consistency rule of this paragraph (c)(3)(i) is satisfied only if the

individual elects the coverage under the spouse's or dependent's

employer. See the Examples in paragraph (k) of this section for

illustrations of the consistency rule.

(ii) Exception for COBRA. Notwithstanding paragraph (c)(3)(i) of

this section, if the employee, spouse, or dependent becomes eligible

for continuation coverage under the employer's group health plan as

provided in section 4980B or any similar State law, the employee may

elect to increase payments under the employer's cafeteria plan in order

to pay for the continuation coverage.

(4) Consistency rule for group-term life insurance coverage. Except

as provided in this paragraph (c)(4), the provisions of paragraph

(c)(3)(i) of this section apply to group-term life insurance coverage.

In the case of marriage, birth, adoption, or placement for adoption, a

cafeteria plan can allow an election change to increase (but not to

reduce) the amount of the employee's life insurance coverage. In the

case of divorce, legal separation, annulment, or death of a spouse or

dependent, a cafeteria plan may allow an election change to reduce (but

not to increase) the amount of the employee's life insurance coverage.

(d) Judgment, decree, or order. This paragraph (d) applies to a

judgment, decree, or order (``order'') resulting from a divorce, legal

separation, annulment, or change in legal custody (including a

qualified medical child support order defined in section 609 of the

Employee Retirement Income Security Act of 1974) that requires accident

or health coverage for an employee's child. Notwithstanding the

provisions of paragraph (c) of this section, a cafeteria plan may--

(1) Change the employee's election to provide coverage for the

child if the order requires coverage under the employee's plan; or

(2) Permit the employee to make an election change to cancel

coverage for the child if the order requires the former spouse to

provide coverage.

(e) Entitlement to Medicare or Medicaid. If an employee, spouse, or

dependent who is enrolled in an accident or health plan of the employer

becomes entitled to coverage (i.e., enrolled) under Part A or Part B of

Title XVIII of the Social Security Act (Medicare) or Title XIX of the

Social Security Act (Medicaid), other than coverage consisting solely

of benefits under section 1928 of the Social Security Act (the program

for distribution of pediatric vaccines), a cafeteria plan may permit

the employee to make an election change to cancel coverage of that

employee, spouse or dependent under the accident or health plan.

(f) Changes in status for other qualified benefits. [Reserved].

(g) Significant coverage or cost changes. [Reserved].

(1) Employer's plan. [Reserved].

(2) Plan of spouse's or dependent's employer. [Reserved].

(h) Cessation of required contributions. [Reserved].

(i) Special requirements concerning the Family and Medical Leave

Act. [Reserved].

(j) Elective contributions under a qualified cash or deferred

arrangement. The provisions of this section do not apply with respect

to elective contributions under a qualified cash or deferred

arrangement (within the meaning of section 401(k)) or employee

contributions subject to section 401(m). Thus, a cafeteria plan may

permit an employee to modify or revoke elections in accordance with

sections 401(k) and 401(m) and the regulations thereunder.

(k) Examples. The following examples illustrate the rules of this

section. In each case involving an accident or health plan, assume that

the plan is subject to section 9801(f) (providing for special

enrollment rights under certain group health plans).

Example 1. (i) Employer M provides health coverage for its

employees under which employees may elect either employee-only

coverage or family coverage. M also maintains a calendar year

cafeteria plan under which qualified benefits, including health

coverage, are funded through salary reduction. M's employee, A,

elects employee-only health coverage before the beginning of the

calendar year. During the year, A adopts

[[Page 60168]]

a child, C. Within 30 days thereafter, A wants to revoke A's

election for employee-only health coverage and obtain family health

coverage, as of the date of C's adoption. A satisfies the conditions

for special enrollment of an employee with a new dependent under

section 9801(f)(2), so that A may enroll in family coverage under

M's accident or health plan in order to provide coverage for C,

effective as of the date of C's adoption.

(ii) In this Example 1, M's cafeteria plan may permit A to

change the employee's salary reduction election to family coverage

for salary not yet currently available. The increased salary

reduction could reflect the cost of family coverage from the date of

adoption. (The adoption of C is also a change in status, and the

election of family coverage is consistent with that change in

status. Thus, under the change in status provisions of paragraph (c)

of this section, M's cafeteria plan could permit A to elect family

coverage prospectively in order to cover C for the remaining portion

of the coverage period.)

Example 2. (i) The employer plans and permissible coverage are

the same as in Example 1. Before the beginning of the calendar year,

Employee A elects employee-only health coverage under M's cafeteria

plan. A marries B during the plan year. B's employer, N, offers

health coverage to N's employees, and, prior to the marriage, B had

elected employee-only coverage. A wants to revoke the election for

employee-only coverage, and is considering electing family health

coverage under M's plan or obtaining family health coverage under

N's plan.

(ii) In this Example 2, A's marriage to B is a change in status.

Two possible election changes by A would be consistent with the

change in status: to cover A and B by electing family health

coverage under M's plan, or to cancel coverage under M's plan (with

B electing family health coverage under N's plan in order to cover A

and B). Thus, M's cafeteria plan may permit A to make either change

in election. (M's cafeteria plan could also permit A to change A's

salary reduction election to reflect the change to family coverage

under M's group health plan in accordance with paragraph (b) of this

section because the marriage would also create special enrollment

rights under section 9801(f), pursuant to which an election of

family coverage under M's plan would be required to be effective no

later than the first day of the first calendar month beginning after

the completed request for enrollment is received by the plan.)

Example 3. (i) Employee G, a single parent, elects family health

coverage under a calendar year cafeteria plan maintained by Employer

O. G and G's 21-year old child, H, are covered under O's health

plan. During the year, H graduates from college. Under the terms of

the health plan, dependents over the age of 19 must be full-time

students to receive coverage. G wants to revoke G's election for

family health coverage and obtain employee-only coverage under O's

cafeteria plan.

(ii) In this Example 3, H's loss of eligibility for coverage

under the terms of the health plan is a change in status. A

revocation of G's election for family coverage and new election of

employee-only coverage is consistent with the change in status.

Thus, O's cafeteria plan may permit G to elect employee-only

coverage.

Example 4. (i) Employee J is married to K and they have one

child, S. A calendar year cafeteria plan maintained by Employer P

allows employees to elect no health coverage, employee-only

coverage, employee-plus-one-dependent coverage, or family coverage.

Under the plan, before the beginning of the calendar year, J elects

family health coverage for J, K, and S. J and K divorce during the

year and, under the terms of P's accident or health plan, K loses

eligibility for P's health coverage. S does not lose eligibility for

health coverage under P's plan upon the divorce. J now wants to

revoke J's election under the cafeteria plan and elect no coverage.

(ii) In this Example 4, the divorce is a change in status. A

change in the cafeteria plan election to cancel health coverage for

K is consistent with that change in status. However, the divorce

does not affect J's or S's eligibility for health coverage.

Therefore, an election change to cancel J's or S's health coverage

is not consistent with the change in status. The cafeteria plan,

however, may permit J to elect employee-plus-one-dependent health

coverage.

Example 5. (i) The facts are the same as Example 4, except that,

before the beginning of the year, Employee J elected employee-only

health coverage (rather than family coverage). Pursuant to J s

divorce agreement with K, P s health plan receives a qualified

medical child support order (as defined in section 609 of the

Employee Retirement Income Security Act) during the plan year. The

order requires P s health plan to cover S.

(ii) In this Example 5, P's cafeteria plan may change J's

election from employee-only health coverage to employee-plus-one-

dependent coverage in order to cover S.

Example 6. (i) Before the beginning of the coverage period,

Employee L elects to participate in a cafeteria plan maintained by

L's Employer, Q. However, in order to change the election during the

coverage period so as to cancel coverage, and by prior understanding

with Q, L terminates employment and resumes employment one week

later.

(ii) In this Example 6, under the facts and circumstances, in

which a principal purpose of the termination of employment was to

alter the election and reinstatement of employment was understood at

the time of termination, L does not have a change in status.

However, L's termination of employment would constitute a change in

status, permitting a cancellation of coverage during the period of

unemployment, if L s original cafeteria plan election was reinstated

upon resumption of employment (for example, because of a cafeteria

plan provision requiring an employee who resumes employment within

30 days, without any other intervening event that would permit a

change in election, to return to the election in effect prior to

termination of employment).

Example 7. (i) Employer R maintains a calendar year cafeteria

plan under which full-time employees may elect coverage under one of

three benefit package options provided under an accident or health

plan: an indemnity option or either of two HMO options for employees

that work in the respective service areas of the two HMOs. Employee

T, who works in the service area of HMO #1, elects the HMO #1

option. During the year, T is transferred to another work location

which is outside the HMO #1 service area and inside the HMO #2

service area.

(ii) In this Example 7, the transfer is a change in status and,

under the consistency rule, the cafeteria plan may permit T to make

an election change to either the indemnity option or HMO #2, or to

cancel accident or health coverage.

Example 8. (i) A calendar year cafeteria plan maintained by

Employer S allows employees to elect coverage under an accident or

health plan providing indemnity coverage and under a flexible

spending arrangement (FSA). Prior to the beginning of the calendar

year, Employee U elects employee-only indemnity coverage, and

coverage under the FSA for up to $600 of reimbursements for the year

to be funded by salary reduction contributions of $600 during the

year. U's spouse, V, has employee-only coverage under an accident or

health plan maintained by V's employer. During the year, V

terminates employment and loses coverage under that plan. U now

wants to elect family coverage under S's accident or health plan and

increase U's FSA election.

(ii) In this Example 8, V's termination of employment is a

change in status. The cafeteria plan may permit U to elect family

coverage under S's accident or health plan, and to increase U's FSA

coverage.

Example 9. (i) Employer T provides group-term life insurance

coverage as described under section 79. Under T's plan, an employee

may elect life insurance coverage in an amount up to the lesser of

his or her salary or $50,000. T also maintains a calendar year

cafeteria plan under which qualified benefits, including the group-

term life insurance coverage, are funded through salary reduction.

Before the beginning of the calendar year, Employee W elects $10,000

of life insurance coverage, with W s spouse, X, as the beneficiary.

During the year, a child is placed for adoption with W and X. W

wants to increase W's election for life insurance coverage to

$50,000 (without changing the designation of X as the beneficiary).

(ii) In this Example 9, the placement of a child for adoption

with W is a change in status. The increase in coverage is consistent

with the change in status. Thus, W's cafeteria plan may permit W to

increase W's life insurance coverage.

(1) Effective Date. This section is effective for plan years

beginning after December 31, 1998.

Michael P. Dolan,

Acting Commissioner of Internal Revenue.

Dated: October 10, 1997.

Donald C. Lubick,

Acting Assistant Secretary of the Treasury.

[FR Doc. 97-29087 Filed 11-6-97; 8:45 am]

BILLING CODE 4830-01-U