IRS Proposes New Regulations for Cafeteria Plans

The Internal Revenue Service recently proposed a consolidated set of new regulations for cafeteria plans (frequently called flexible spending or Section 125 plans) that will provide a detailed compliance roadmap for its auditors. This comes after many years of the IRS providing only piecemeal guidance for such plans. Although the IRS has not specifically announced that it will be stepping up enforcement regarding cafeteria plans, it seems inevitable. As a result, employers would be well advised to pay more attention to their cafeteria plan documentation, administration and nondiscrimination testing than they may have in the past.

The new proposed regulations generally consolidate existing regulations and guidance, without introducing large-scale changes. They cover general cafeteria plan operating rules, participant elections, flexible spending arrangements, claims substantiation, and nondiscrimination testing. The IRS previously finalized rules regarding Family and Medical Leave Act (FMLA) leaves and mid-year election changes, so the new regulations do not address those topics. Subject to one exception noted below, the regulations are proposed to become effective for plan years beginning on or after Jan. 1, 2009. However, employers can immediately rely on the proposed regulations for guidance pending issuance of the final regulations.

While the scope of the new regulations is too large to be able to provide a detailed analysis of them in this brief Alert, they will require all employers with cafeteria plans to take certain action steps. To assure that any cafeteria plan you sponsor is in compliance, you should:

• Review with your third-party administrator and your legal counsel all of your cafeteria plan documents and participant communications to see whether changes need to be made based on new provisions in the regulations. In particular, make sure that the way your plan is being administered matches what your plan documents say. Under the new regulations, failure to follow the terms of your cafeteria plan document (or to have adequate plan documents at all) will disqualify the entire cafeteria plan and make your employees taxable on their benefits—a serious consequence that employers will want to avoid.


• If you provide life insurance to employees through your cafeteria plan, review your method of imputing income to employees. Under a provision of the proposed regulations that is effective immediately, only the Table I cost of life insurance over $50,000 is included in an employee's taxable income. (Previously, the employee's salary reduction amount had to be taken into account.)


• Review the methods you are using to perform nondiscrimination testing of your cafeteria plan—or begin performing nondiscrimination tests if you haven't been doing them. Although nondiscrimination rules have applied to cafeteria plans for many years, there has been widespread confusion over how to apply those rules, which has led many employers to choose not to perform the tests. The new proposed regulations now provide more detailed guidance on how and when these tests must be performed. Presumably, once the regulations are finalized, the IRS will begin scrutinizing cafeteria plan discrimination issues more carefully than in the past.