2 See, Prop. Treas. Reg. §1.125-1, Q&A-1 through -8.
3 I.R.C. §125(d)(1)(A). See, Prop. Treas. Reg. §1.125-1, Q&A-4 for definition of employee.
4 See, Prop. Treas. Reg. §1.125-1, Q&A-8 and Q&A-15; Rev. Rul. 2002-27.
5 See, Prop. Treas. Reg. §§1.125-1, Q&A-3; 1.125-2, Q&A-3.
PERMISSIBLE AND IMPERMISSIBLE BENEFITS
A cafeteria plan is defined under Section 125 of the Internal Revenue Code as an arrangement under which an employee has a choice among two or more benefits consisting of “qualified” — i.e., tax-preferred benefits and cash. Specifically, Section 125 requires cafeteria arrangements to offer both a cash benefit and at least one qualified nontaxable benefit.6 Therefore, a plan that offers a choice between only two or more nontaxable benefits is not a Section 125 cafeteria plan.
Benefits that may be included in a cafeteria plan are those that do not defer the receipt of compensation by the employee from one year to the next, and are excludable from the gross income of employees under the internal revenue code. They include:7
- Accident and health plans;
- Group term life insurance;
- Dependent care assistance;
- Elective contributions to a qualified cash-or-deferred arrangement;
- Elective vacation days.
NOTE: Employers may include group life-insurance coverage in excess of $50,000 in a cafeteria plan, even though FIT and FICA taxes apply to the excess amount of coverage.
6 I.R.C. §125(d)(1)(B).
7 I.R.C. §125(f); See, Prop. Treas. Reg. §§1.125-1, Q&A-5; 1.125-2, Q&A-1 and Q&A-4.
ELECTIVE VACATION DAYS8
Cafeteria plans may include elective paid-vacation days as a benefit. Under such arrangements, participants may use pre-tax contributions to purchase extra paid-vacation days. However, since cafeteria plans may not operate in a manner that “defers income,” elective vacation days must be used within the plan year for which the employee made the election. In applying this rule, employees always are assumed to take their regular vacation days before using elective days.
A plan may permit employees to sell vacation days back to the plan as long as employees elect to “cash out” unused vacation days before the earlier of: (1) the end of the last day of the plan year; or (2) the last day of the employee's tax year to which the employee's elective contributions relate. Since elective vacation days cannot be rolled over to the next plan year, a plan provision that allows employees to sell leave back to the plan permits employees to keep elective contributions that otherwise would have had to have been forfeited. Of course, any amounts that are “cashed-out” are taxable as regular income.
A day of vacation is considered an elective day if the employee could have sold it back to the plan, even if he/she chose not to do so. In addition, elective days are considered to be the last vacation days used.
8 See, Prop. Treas. Reg. §§1.125-1, Q&A-7; 1.125-2, Q&A-5(c).
IMPERMISSIABLE BENEFITS INCLUDE:9
There are certain nontaxable benefits that may not be included in a cafeteria plan. They include:
- Scholarships, fellowships, educational assistance, and tuition reduction;
- Fringe benefits qualifying as no-additional-cost services, qualified employee discounts, working condition fringes, de minimis fringes, qualified transportation fringes, or qualified moving expense reimbursements;
- Meals and lodging furnished for the convenience of the employer; and
- Deferred compensation arrangements (other than Section 401(k) plans).
Prohibited benefits that would otherwise be excludable from employee's income become taxable if included in a cafeteria plan.
9 See, Prop. Treas. Reg. §§1.125-2.
RESTRICTION AGAINST DEFERRED INCOME10
A cafeteria plan may not include any benefit that defers the receipt of compensation to another year, except for contributions to a Section 401(k) plan. A cafeteria plan would violate this restriction if it permitted participants to carry over unused elective contributions or benefits from one plan year to another. Likewise, contributions for one plan year may not be used to purchase a benefit that will be provided in a subsequent plan year. For example, any type of disability or long-term care plan, or insurance coverage with a savings or investment feature, such as whole-life insurance, may not be included in a cafeteria plan. In the same way, a cafeteria plan may not include a health expense flexible spending account that reimburses employee premium payments for other accident or health coverage extending beyond the end of the plan year.
10 See, Prop. Treas. Reg. §§1.125-1, Q&A-7; 1.125-2, Q&A-5.
TYPES OF PLANS11
Flexible benefit programs can be made as simple or as complex as the employer desires. Since administrative costs really are a function of plan design, costs can be kept low if the plan is kept simple. Although flex plans vary from company to company, most plans incorporate at least some features from the following “prototype” plans:
- Premium-Only Plans — Premium-only plans, also known as “POPs” or premium conversion plans, generally are suited to small employers that require their employees to contribute toward benefits. POPs do not provide employees with a range of benefit choices, but merely allow employees to pay their share of benefit costs on a pre-tax basis by agreeing to a salary reduction in the amount of the required employee contribution. With a POP, employers that do not have the resources to offer benefit choices, can still take advantage of a cafeteria plan's tax efficiencies.
- Add-On Flexible Benefits — Under this approach, a range of benefit options is added to the existing nonflexible benefits program. Employees are given an allowance of flexible credits to apply toward the benefit choices. If the cost of the supplemental coverages is less than the allowance, the excess allowance is given to the employee in cash. If the cost of the supplemental coverages is greater than the allowance, the employee pays for the additional cost with after-tax employee contributions. Any excess credits may be taken by the employee in cash.
- Shrink-to-Core Approach — The “shrink to core” approach takes the traditional benefits program and divides it into two parts. The first part is a reduced level of nonflexible benefits known as “core benefits.” Core benefits — typically major medical coverage and life insurance — are mandatory for all employees. The second part consists of a range of benefit options that employees may purchase with flexible credits or flexible dollars that are created by cutting back the nonflexible program. A set amount of flexible dollars are allocated to employees at the beginning of each plan year. If employees choose benefits that in aggregate cost less than the total number of flexible credits allocated to them, they may receive the excess credits in cash.
- Modular Approach — Under this approach, the employer offers several preset benefit packages designed for selected employee groups, such as young single employees, single parents, married workers with dependents, and those nearing retirement. Such “modules,” or packages of benefits essentially are of equal value. For example, a low-deductible health plan might be combined with a minimum-coverage disability program or a high-deductible health plan might be combined with a maximum-coverage disability plan. A modular approach may be suitable for a small employer, since it reduces the administrative complexity of the plan.
- Reimbursement Accounts — A flex plan may incorporate reimbursement or “flexible spending accounts” (FSAs). FSAs allow employees to pay for certain expenses — i.e., medical, dental, vision, or child care expenses — with pre-tax dollars. Prior to the beginning of each plan year, employees elect the amount of salary-reduction dollars or flexible credits they wish to allocate to an FSA. Such amounts then are used by the employer to reimburse employees for “qualified expenses” incurred during the plan year. Any amounts remaining in the account at the end of the plan year must be forfeited by the employee.
11 Beam Jr., Burton T. & McFadden, John J., Employee Benefits 6th Ed., (Illionois: Dearborn Finanical Publishing, Inc., 2001),
Chp. 17, Cafeteria Plans.
FUNDING FLEXIBLE BENEFITS
There are two basic mechanisms which can be used singly or in combination for funding flexible benefit arrangements:12
- “Flex Dollars” or “Credits” — Where flexible benefits are funded by employer contributions, the employer allocates a designated amount of “flexible dollars” or “flexible credits” to each employee. Employees use flex dollars to purchase selected benefits from a menu of benefit options, or they can elect to receive the flex dollars in cash.
- Salary Reduction — Under this approach employees' benefit choices are funded by the employees agreeing to having their gross salaries reduced by the amount necessary to purchase the tax-preferred benefits options that they select.
Of course, deductions from employee's after-tax wages also may be used to purchase any taxable benefits outside the formal cafeteria plan that also are offered on the employer's flexible benefits menu.
12 See, Prop. Treas. Reg. §1.125-1, Q&A-2.
GETTING STARTED: NEEDS ASSESSMENT
A cafeteria plan is a great way for both the employer and employees to save on taxes, and it can allow the employer to provide benefits that make the most sense to its employees. Since flexible benefit plans are not appropriate for all employers, a firm should conduct a thorough “needs assessment” to determine if a flex plan would support the strategic goals of the organization, as well as meet the benefit requirements of employees. By going through a needs assessment phase of planning, a firm is able to “put on the brakes” should it appear that a flex plan would not meet organization objectives or would not be favored by employees.
The basic steps of the needs assessment process are as follows:
- Study employee demographics to gauge the extent of workforce diversity.
- Estimate the extent to which employees receive duplicate coverage — i.e., benefit coverage that duplicates what the employee receives under another plan, such as the plan maintained by the employer of a spouse — that they may be willing to trade for other benefits.
- Analyze employees' benefit preferences and their likely response to the prospect of flexible benefits.
- Compare the projected costs under flex with those forecasted under the current plan;
- Evaluate how a flex plan would fit with the prevailing corporate values and “culture.”
- Determine whether a flex program supports the company's long-term business strategy and whether it would receive continuing support from top management.
Where cost containment is a primary reason for adopting a flex plan, it is advisable that management be candid with employees about the firm's motives. In many cases, by presenting evidence of the benefit cost increases faced by the organization, employees can be convinced that flex is more fair and more desirable than other cost-saving measures, such as benefit reductions or direct cost sharing. Employees also may be swayed by showing them how they would be able to select an individualized benefits package, and that where employees trade in duplicative or unwanted coverage they may receive cash or other needed benefit coverage.
WRITING REQUIREMENTS13
To qualify under Section 125 of the Internal Revenue Code, a cafeteria plan must be in writing and intended as a permanent plan. The plan document must contain:
- Descriptions of each of the benefits available under the plan and their respective periods of coverage;
- Rules governing eligibility and participation;
- A description of the benefits election procedures, including the period during which elections may be made, the extent to which elections are irrevocable, and the period with respect to which elections are effective;
- A statement of the manner in which employer contributions are made, such as by salary reduction agreements between the employer and employees or by non-elective employer contributions;
- A declaration of the maximum amount of employer contributions available to any participant under the plan; and
- The definition of the plan year on which the cafeteria plan operates.
Advance IRS approval is not available for cafeteria plans. Thus, a plan must be especially careful that the plan document as well as the operations of the plan are always in compliance with tax code requirements. Failure to do so could subject result in the taxation of the benefits provided to employees under the plan. In such a case, the employer could be subject to penalties for failure to withhold payroll taxes.
When describing the benefits available under a cafeteria plan, the plan document may incorporate by reference the separate written plan documents for each benefit instead of setting forth the terms of such document in full. Employers offering a salary reduction option for medical or dependent care expenses must maintain separate written plan documents for each reimbursement option.
In satisfying the writing requirement, a special rule requires that the employer state in the plan document the maximum amount of salary reduction contributions available to any employee under the plan. An employer may set this maximum by specifying a dollar amount, a percentage of pay, or a method for determining the maximum. It may be advisable for the limit to be stated as a formula, so that the plan document need not be amended each time adjustments are made in connection with the limit.
13 See, Prop. Treas. Reg. §1.125-1, Q&A-3, 1.125-2, Q&A-3.
REPORTING AND RECORDKEEPING REQUIREMENTS14
Like other benefit plans, cafeteria plans must comply with reporting requirements under the Internal Revenue Code. Generally, employers with cafeteria plans are required to file an annual report with the Department of Labor on Form 5500. Employers have until no later than the last day of the seventh month after the end of the plan year to file the report. Minimum information required in the report includes:
- The number of employees of the employer;
- The number actually participating in the plan;
- The total cost of the plan for the taxable year;
- The name, address, and taxpayer identification number of the employer; and
- The type of business in which the employer is engaged.
There may be additional reporting requirements if the cafeteria plan qualifies as an “employee welfare benefit plan” under the Employee Retirement Income Security Act (ERISA).
14 I.R.C. §§125(h); 6039(D).
PROS AND CONS15
Flex plans are popular for a number of reasons:
- Workforce Diversity — Flex plans are able to accommodate the varied benefit needs of two-career couples, single working parents, older workers, and the other employees that makeup today's diverse workforce. In contrast, many conventional benefit plans are designed to meet the needs of a declining segment of the workforce — i.e., married employees with a spouse at home who cares for children.
- Tax Savings — Under cafeteria plans, benefits generally are paid for with pretax credits or through salary reduction so that employees save both federal and state income taxes, as well as FICA taxes. In turn, employers pay less FICA, FUTA, and state taxes (in states that follow the federal standard) because the employees' gross taxable incomes are marginally reduced.
- Savings From Eliminating Duplicate Coverage — Flex plans provide a strong incentive for employees to eliminate “duplicate” health care coverage, since employees generally may take their part of any premium savings home as cash or apply such amounts toward other benefits. Because of these incentives to drop duplicate coverage, employers — particularly those with a significant percentage of employees with working spouses — usually realize substantial first-year health-care cost savings after converting to flex.
- Recruitment and Retention — The opportunity to choose an individualized benefits package can help attract and retain valued employees. For instance, employees covered under a spouses' health plan may welcome the chance to take home extra cash by eliminating the duplicate coverage. Other employees may appreciate the tax efficiencies of reimbursement accounts that permit them to pay dependent care or medical expenses with pre-tax dollars.
- Controlling Benefits Costs — Flex plans permit employers to decide in advance of each plan year the amount of “flex dollars” they wish to allocate to employee benefits. This “defined contribution” approach gives the employer more control over benefits costs than found under traditional plans that typically commit an employer to providing a specific level of coverage. Flex plans also may help contain costs by providing employees with incentives to use “managed-care” health coverage options — i.e., PPOs or HMOs. In addition, an employer may find it easier to introduce cost-sharing measures in a flexible benefits plan. New or increased medical deductibles, for instance, may be more palatable to employees if a medical flexible spending account is offered so that employees may pay for the deductible on a pre-tax basis.
- Employee Appreciation — Some companies find that workers better understand and appreciate their benefits when provided through a flexible arrangement. By involving employees in selecting their own benefit packages and giving them responsibility to allocate “flexible dollars or credits” these employers find that their employees are better aware of benefit costs. Moreover, the employees tend to value the benefits that they select more than those which they would receive as a matter of course under a traditional plan.
Despite the many advantages attributed to flexible benefits, they are regarded by many employers as being costly to implement, difficult for employees to understand, and administratively cumbersome. Among other criticisms leveled at flexible benefits plans are:
- Flex plans are complicated — A “full blown” flex plan may be too cumbersome for some small and medium-sized companies to administer. However, backers of the flex approach contend that there are design variations that do not pose significant administrative difficulties. They also point out that the availability of microcomputer-based software can simplify flex plan administration and make flexible benefits feasible.
- Flex plans require more staff — Flex plans pose more of an administrative burden than most conventional plans and may necessitate additional benefits staff. The workload may be particularly heavy during the yearly benefits enrollment period. However, flex plan proponents claim that except for enrollment periods, during which temporaries may be hired, a flex program does not necessarily require more benefits personnel.
- Consultants must be hired — Because of the complexity of many flexible benefit programs, employers often must turn to outside experts for help and advice. On the other hand, flex advocates point out that some flex plans are set up without substantial outside help. However, they admit that it always is in the employer's best interest to have a tax expert review a plan for regulatory compliance.
- Employees won't understand flex options — Some employers resist flexible benefits, because they believe employees may be unable able to make intelligent benefit choices. Such employers fear that some employees would leave themselves or their dependents without sufficient benefit coverage or that employees would not understand some of the subtle tax implications of their choices. Flex plan supporters say that employers underestimate the ability employees to make wise benefit choices. They argue that employees are able to draw on their skills as consumers in the broader market of goods and services to select a benefits package that truely suits their needs.
15 Beam Jr., Burton T. & McFadden, John J., Employee Benefits 6th Ed., (Illionois: Dearborn Finanical Publishing, Inc., 2001),
Chp. 17, Cafeteria Plans.
CONCLUSION
While Cafeteria Plans may not be everyone’s idea of a “free lunch”, they can offer a valuable savings benefit for both the employer and employees.