PRACTICAL QUESTIONS AND ANSWERS
There are many questions in the area of cafeteria plan administration due to the fact that so little guidance has been issued by Congress, the Internal Revenue Service (IRS) and the Department of Labor.
Over the past few years we have discussed administration with many CPAS, attorneys, third-party administrators, benefit communicators, insurance agents and the IRS.
What follows is a list of the major issues that have arisen out of these discussions. We have attempted to answer these questions based on our understanding of the law and regulations, and based on informal correspondence with the IRS.
Q. Can we fax our claim forms?
A. Yes. You may fax in your claim forms with the appropriate information filled out and signed. You do not need to send the originals in the mail.
Q. When do we receive our checks?
A. Your checks will be processed and included with your next paycheck from your employer.
Q. Do services have to be paid for prior to my submitting a claim?
A. No. Only the date of service is important. Not the date of payment.
Q. When do I need to submit a claim in order for it to be reimbursed with my next paycheck?
A. If you are mailing your claim, 5-6 business days should be allowed. A faxed claim could be sent up to four days prior to your payday.
Q. How can you predict medical expenses?
A. Normally you can't. If you over estimate your expense you will lose what's left.
Q. What is a Cafeteria Plan under Code Section 125
A. A Cafeteria Plan is a separate written benefit plan maintained by an employer for the benefit of employees under which all participants are employees and each participant has the opportunity to select the particular benefits that he desires. The plan must offer at least one taxable benefit and at least one nontaxable benefit. (Reg. Sec. 1.125-1 Q&A-2)
Q. Can employer contributions to a Cafeteria Plan be made pursuant to a salary reduction agreement between the participant and the employer?
A. Yes. A plan document may provide that the employer will make contributions pursuant to a salary reduction agreement under which participants elect to reduce their compensation or to forego increases in compensation and to have these amounts contributed to the employer on their behalf. (Reg. Sec. 1.125-1 Q&A-6)
Q. Can a Cafeteria Plan offer a benefit that defers the receipt of compensation?
A. No. A Cafeteria Plan cannot offer a benefit that defers the receipt of compensation except for contributions under a qualified cash or deferred arrangement defined in 'Code Section 401(k). (Reg. Sec. 1.125-1 Q&A-7)
A plan that permits employees to carry over unused elective contributions or plan benefits from one plan year to another operates to defer compensation. Thus, this benefit would not be a qualified Cafeteria Plan benefit. Similarly, a Cafeteria Plan operates to permit the deferral of compensation if the plan permits participants to use contributions from one plan year to purchase a benefit that will be provided in a subsequent plan year. (Reg. Sec. 1.125-2 Q&A-5)
Q. Do the rules of Section 125 affect whether any particular benefit offered under a Cafeteria Plan is a taxable or nontaxable benefit?
A. No. A benefit that is nontaxable under the Internal Revenue Code when offered separately is treated as a nontaxable benefit under a Cafeteria Plan. If a benefit that is taxable under the Internal Revenue Code when offered separately is offered under a Cafeteria Plan, the benefit will continue to be a taxable benefit under the Cafeteria Plan. The taxability of an otherwise nontaxable benefit offered under a Cafeteria Plan will be determined using the discrimination test under Code Section 125. (Reg. Sec. 1.125-1 Q&A-16)
Q. Can a participant purchase coverage under a Cafeteria Plan on a month-by-month basis?
A. No. The period of coverage must be 12 months. The Cafeteria Plan's initial plan year can be less than 12 months. (Reg. Sec. 1.125-1 Q&A-17)
Q. Are accidental death and dismemberment policies qualified benefits under a Cafeteria Plan?
A. Yes. Coverage under a long-term disability plan and coverage under an accidental death and dismemberment policy may be qualified benefits under a Cafeteria Plan. (Reg. Sec. 1.125-2 Q&A-4)
Q. Can a participant pay for whole life insurance or universal life insurance premiums through a Cafeteria Plan?
A. No. Life insurance plans with a savings or investment feature, such as whole life, are not qualified benefits under a Cafeteria Plan. (Reg. Sec. 1.125-2 Q&A-5)
Q. Can a sole proprietor, partnership, limited liability company, or S-corporation sponsor a Cafeteria Plan?
A. Yes. These entities can sponsor a Cafeteria Plan and benefit by saving the FICA tax on money put into the Cafeteria Plan.
Q. What is the income tax effect of paying for disability premiums through a Cafeteria Plan?
A. If disability premiums are paid for by the employer with tax-free dollars, any disability benefits will be taxable to the employee. If disability premiums are paid with after-tax dollars by the employee, any disability benefits are tax-free. If disability premiums are paid through a tax-free Cafeteria Plan benefit election, and disability benefits will be taxable to the employee.
Q. Is a Cafeteria Plan required to be based on a calendar year?
A. No. Nothing in the code or regulations requires that a Cafeteria Plan be on a calendar year basis. If the only benefit provided through a Cafeteria Plan is group medical insurance, we would recommend that the Cafeteria Plan year coincide with the medical benefit plan year so that elections to pay for premiums through the Cafeteria Plan will coincide with elections to participate in the medical plan. If the Cafeteria Plan has dependent care benefits or non-reimbursed medical expense benefits, we suggest establishing the Cafeteria Plan on a calendar year basis because participants tend to think in terms of a calendar year when determining their anticipated expenses.
Q. What is a FSA?
A. FSA stands for flexible spending arrangement. (Reg. Sec. 1.125-2 Q&A-7)
Q. What is the purpose of the new FSA rules?
A. The introduction to Reg. Sec. 1.125-2 states that the new FSA rules are intended to protect the integrity of the distinction between the taxable treatment of personal medical expenses and the more favorable tax treatment of employer-provided health plan coverage. There is significant concern that health FSA's operate primarily to exclude from income amounts paid for personal medical expenses that would otherwise only be deductible to the extent that they exceed 7-1/2% of adjusted gross income. This concern is greater if there is no person, such as an employer or insurance company, who bears a risk of experience loss with respect to the health plan, and thus, has an interest in regulating the arrangement to minimize and substantiate claimed expenses.
In order to limit the extent to which health FSA's effectively operate to exclude amounts paid for personal medical expenses, the new regulations apply requirements to health FSA's that are similar to the requirements that an independent health insurer with meaningful risk of loss would apply to protect against inappropriate reimbursement of expenses.
Q. When are the new health FSA rules applicable?
A. The new rules are effective for plan years beginning after December 31, 1989. (Reg.Sec. 1.125-2 Q&A-7)
Q. Is there any way to avoid the risk-shifting and risk-distribution characteristics that must be contained in a health FSA?
A. Yes, but a health FSA will not qualify for tax-favored treatment if the effect of the reimbursement arrangement eliminates all, or substantially all, risk of loss to the employer maintaining the plan. (Reg. Sec. 1.125-2 Q&A-7)
Q. If a participant elects $600 a year for their health FSA, pays the first $50 premium and incurs a $400 expense, must the Cafeteria Plan reimburse the participant for the entire $400 even though they have only paid $50?
A. Yes. The maximum amount of reimbursement under a health FSA must be available at all times during the period of coverage. The maximum amount of reimbursement at a particular time -during the period of coverage cannot relate to the extent to which the participant has paid the premiums for the coverage. The payment schedule for the premiums may not be based on the rate or amount of covered claims incurred. Reimbursements must be paid at least monthly. (Reg. Sec. 1.125-2 Q&A-7)
Q. What would you recommend to mitigate the potential risk of loss of the employer?
A. First of all, set the level of reimbursable expenses at a reasonable amount, such as $600 to $1,200 per year. I would suggest a longer participant eligibility period for the health FSA.
Q. Can a health FSA reimburse a participant for other health insurance coverage?
A. No. Starting in 1990, a health FSA may not treat participants' premium payments for other health coverage as reimbursable expenses. Specifically, a health FSA may not reimburse participants for premiums paid for health coverage under a plan maintained by the employer of the participant's spouse or dependent. (Reg. Sec. 1.125-2 Q&A-7)
Q. Can a Cafeteria Plan be used to pay the premiums for a group of individual health insurance policies, or must that benefit be a group health insurance policy sponsored by the employer?
A. The IRS has recently verbally confirmed that individual policies can be paid for through a Cafeteria Plan. The new FSA rules prevent a participant from being reimbursed for other health coverage under the health FSA, but this rule does not prevent premiums for current health plan coverage from being paid on a salary reduction basis through the ordinary operation of the Cafeteria Plan. (Reg. 1.125-2 Q&A-7)
Q. Must health FSA claims and dependent care claims be substantiated?
A. Yes. Starting in 1990 a health FSA and dependent care plan may reimburse an expense only if the participant provides a written statement from an independent third party stating that the expense has been incurred and the amount of such expense. In the case of medical expenses the participant must also provide a written statement that the medical expense has not been reimbursed, or is not reimbursable under any other health plan coverage. (Reg. Sec. 1.125-2 Q&A-7)
Q. Can a participant revoke exsisting elections and make new elections under a Cafeteria Plan?
A. Yes. Under certain circumstances participants can change their elections. If a new election is permitted, then such new election must be consistent with the reason that such change was permitted. (Reg. Sec. 1.125-2 Q&A-6 and Reg. Sec. 1.125-YT.)
Q. Is an employer required to allow participants to change their elections?
A. No. Nothing in the code or regulations requires an employer to permit participants to revoke their benefit elections. This is optional. (Reg. Sec. 1.125-2 Q&A-6)
Q. Under which circumstances may a Cafeteria Plan permit an election change?
A. A Cafeteria Plan may permit a participant to revoke a benefit election during a period of coverage and make a new election for the remaining portion of the period if the revocation and new election are both on account of a change in status event and are consistent with such change in status event.
Examples of a change in status event include events that change an employee's legal marital status, including marriage, death of a spouse, divorce, legal separation, or annulment. Events that change an employee's number of dependents, including birth, adoption, placement for adoption, death of a dependent or a court order resulting in a change in legal custody. A termination or commencement of employment by the employee, spouse, or dependent. A reduction or increase in hours of employment by the employee, spouse dependent, including a change from part-time to full-time, from full-time to part-time, a strike or lockout, or commencement or return from an unpaid leave of absence.
Election changes are also permitted if the employee, spouse, or dependent gains or loses 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. (Reg. Sec. 1.125-4T)
Election changes are also permitted where there has been a significant change in the health coverage of the employee or spouse attributable to the spouses employment. Benefit election changes are consistent with status changes only if the election changes are necessary or appropriate as a result of the status changes. (Reg. Sec. 1.125-2 Q&A-6)
Q. Can a Cafeteria Plan adjust the participants' elective contributions for health insurance premiums if the premium amount changes?
A. If the cost of a health plan provided by an independent, third-party provider under a Cafeteria Plan increases or decreases during a plan year, the Cafeteria Plan may automatically increase or decrease all affected participants' elective contributions for such health plan. If the premium amount significantly increases, a Cafeteria Plan may also permit participants to either make corresponding changes to their premium payments or to revoke their elections and, in lieu thereof, to receive on a prospective basis similar coverage under another health plan. If the coverage under a health plan is significantly curtailed or ceases during a period of coverage, a Cafeteria Plan may permit all affected participants to revoke their elections of the health plan, and to receive on a prospective basis similar coverage under another health plan. (Reg. Sec. 1.125-2 Q&A-6)
Q. Can terminated participants revoke their elections?
A. Yes, if the plan so provides. A Cafeteria Plan may permit, but is not required to permit an employee who separates from service during a period of coverage to revoke existing benefit elections and terminate the receipt for the remaining portion of the coverage. A Cafeteria plan may also provide that a benefit will cease to be provided to an employee if the employee fails to make the required premium payments with respect to the benefit. (Reg. Sec. 1.125-2 Q&A-6)
Q. If a participant elects to pay for medical insurance premiums through a Cafeteria Plan and then unilaterally drops the coverage without a valid change in family status, can the employer reinstate the original salary?
A. Technically no. Unless there is a change in family status or a significant change in the cost of coverage, the plan cannot allow for an upward salary adjustment. Any bonus increase in pay would have to be independent of the Cafeteria Plan. Also, any arrangements formally outside of the Cafeteria Plan to adjust a participant's compensation in such an event would be scrutinized.
Q. What does the term "employee" mean under Code Section 125?
A. The term "employee" includes present and former employees of the employer. The term does not include self-employed individuals. Partners in a partnership would considered self-employed, and therefore, would also not be considered employees for purposes of Code Section 125.
All employees who are treated as employed by a single employer under Code Section 414 (b), (c), or (m), are treated as employed by a single employer for purposes of Code Section 125. (Reg. Sec. 1.125-1 Q&A-4)
Q. Can a Cafeteria Plan benefit spouses and beneficiaries of participants?
A. Even though spouses and other beneficiaries of participants may not be participant in a Cafeteria Plan, the plan may indirectly provide benefits to spouses and beneficiaries For example, the spouse of a participant may benefit from the participant's selection of family medical insurance coverage or of coverage under a dependent care assistance program. (Regulation Section 1.125-1 Q&A-4)
Q. Can a sole proprietor, partner, member of a limited liability company, or more than 2% shareholder in an S corporation participate in a Cafeteria Plan?
A. No Under the provisions of Reg. Sec. 1.125-1 Q&A-4, a sole proprietor would not be allowed to participate in a Cafeteria Plan. A partner in a partnership or a member in most limited liability companies would be considered similar to a sole proprietor. Under the provisions of Co(-le Sec. 1372, no more than 2% shareholder in an S corporation is treated a partner in a partnership for certain fringe benefit purposes including participation in Cafeteria Plan.
Q. When are medical and dependent care expenses incurred for purposes of a Cafeteria Plan?
A. Expenses are treated as having been incurred when the participant is provided with the medical care or the dependent care that gives rise to the expense, and not when the participant is formally billed, charged for, or pays for the expense. (Reg. Sec. 1.125-1 Q&A-17 and Q&A-18)
Q. Can a participant request reimbursement for expenses incurred before they sign an election
A. No. Expenses that are incurred before the later of the date the plan is in existence and the date the participant is enrolled in the plan will not be treated as having been incurred during the period for which the participant is covered by the plan. (Reg. Sec. 1.125-1 Q&A-17 and Q&A-18)
Q. If a participant does not use all of his expenses during a plan year, can an employer simply reimburse the participant for any unused expenses?
A. No. Arrangements formally outside of the Cafeteria Plan that provide for the adjustment of a participant's compensation or a participant's receipt of any other benefits on the basis of the expenses incurred or reimbursements received by the participants will be considered in determining whether the reimbursements are provided under a benefit eligible for the exclusion from income tax. (Reg. Sec. 1.125-1 Q&A 17 and 18)
Q. How are future social security benefits affected by Cafeteria Plan elections?
A. It is difficult to determine with reasonable accuracy the effect of a Cafeteria Plan election today on the social security benefits received many years from now. It is true that because Cafeteria Plan elections avoid the FICA tax, future social security benefits will be reduced. Although the plan administrator is not required to inform participants that the future social security benefits may be reduced because of their election, we feel that this important information to give to the plan participants. Several employers offer optional insurance benefits to offset any potential social security benefit losses. Other employers suggest that their employees contribute any tax savings to their 401(k) profit sharing plans.
Q. Do the new rules starting in 1990 regarding health FSA's also apply to dependent care assistance plans?
A. Yes. Analogous rules apply to dependent care assistance plans except for the rule regarding uniform coverage throughout the coverage period. In other words, you only need to reimburse dependent expenses if there is money in the dependent care account. (Reg. 1.125-2 Q&A-7)
Q. If an employee has dependent care expenses, is it better to take the credit, or elect to pay the expenses through the Cafeteria Plan?
A. It depends on the adjusted gross income of the participant. The dependent care credit goes from 30% to 20% as the adjusted gross income increases from $10,000 to $30,000. If you assume that a participant pays 15% federal income tax, 5% state income tax, and 7.65% FICA tax, you would want to compare this tax savings with the potential tax credit. The point where the tax savings of 27.65% equals the tax credit of 28% is approximately $12,000 to $14,000 in adjusted gross income. Therefore, as a general rule, if a person's adjusted gross income is greater than $14,000, they would be better off using the Cafeteria Plan to pay for dependent care expenses.
If the participant's adjusted gross income is less than $14,000, they would be better off taking the dependent care credit. These are only general rules and other factors may be involved.
Q. What is the effect of reimbursement of dependent care expenses on the dependent care credit?
A. Under the Family Support Act of 1988, any reimbursed dependent care expenses must be used to offset the child care credit. For example, if a participant has one child they are entitled to a credit on expenses up to $2,400. Assuming they are reimbursed $1,000 under a dependent care plan, they would only be able to claim a credit on the difference between $2,400 and $1,000, or $1,400.
Q. How does the Cafeteria Plan election affect an employee receiving minimum wage?
A. The Department of Labor has taken the position that Cafeteria Plan benefits are includeable as wages, and therefore, a salary reduction plan will not affect the minimum wage laws.
Q. How does a Cafeteria Plan election affect contributions to retirement plans and the annual addition limitation?
A. A Cafeteria Plan could reduce contributions to retirement plans if the definition of compensation for purposes of a retirement plan contribution includes only taxable compensation. A retirement plan can be amended to include Cafeteria Plan contributions as compensation for purposes of the contribution. Only the taxable compensation will be included in determining the annual addition limitation. (Code Sec. 415(c) and 414(s))
Current Law Changes
Q. What are the new rules regarding cosmetic surgery?
A. The Revenue Reconciliation Act of 1990 created a new rule for unnecessary cosmetic surgery effective in 1991. It states that expenses paid for unnecessary cosmetic surgery or other similar procedures are not deductible medical expenses. Also, amounts paid for insurance coverage for such expenses are not deductible and any reimbursements for such expenses are not excludable from gross income. Some examples of unnecessary cosmetic surgery listed in the committee reports are hair removal electrolysis, hair transplants, lyposuction, and face lift operations. (Code Sec. 213(d))
Q. What are the new rules regarding long term care?
A. Long term care premiums are no longer eligible under Section 125. Also long term care expenses can no longer be reimbursed under the Health FSA Plan. (Reg. Sec. 1.125-3)
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