Changes to cafeteria plan revocations and elections necessitate plan qualification review.

On Nov. 7, 1997, the IRS issued Temp. Regs. Sec. 1.125-4T, effective on Dec. 31, 1998, and new Prop. Regs. Secs. 1.125-1, Q&A-8 and 1.125-2, Q&A-6, replacing guidance issued originally in 1984 and 1989, respectively, on revocations and elections made to cafeteria plans. These regulations are effective for plan years beginning after 1998. During the interim, the taxpayer may rely either on the new temporary and proposed regulations or on the earlier proposed regulations. Plan documents, administrative procedures and employee communications should be reviewed and changed as needed, no later than Dec. 31, 1998, to ensure that cafeteria plan revocation and election procedures fully comply with the new regulations and thus ensure continued qualification as cafeteria plans under Sec. 125.

Cafeteria plans that satisfy Sec. 125 and the regulations allow employees to elect to forgo cash in lieu of receiving certain statutorily excludible benefits (such as medical, disability, accident or health, and group life). In short, such plans allow employees to convert what would otherwise be taxable compensation into excludable benefits suiting their particular needs.

Both the new temporary and proposed regulations and the old proposed regulations provide for revocation and election of cafeteria plan benefits on a change in the employee's or a dependent's status if the change is consistent with that status. The temporary regulations, however, expressly state that the enumerated change-in-status conditions are the exclusive provisions for all elections and revocations. (The original proposed regulations contained no such suggestion of exclusivity.) While providing clear and administratively simple guidelines, the limited circumstances under which the temporary regulations provide for revocations and elections do not necessarily encompass the reality of employment situations; moreover, offering revocation or election possibilities beyond those expressly sanctioned endangers the qualification of those cafeteria plans.

While motivated by the need to allow revocations and elections consistent with the provisions of the Health Insurance Portability and Accountability Act of 1996 (HIPAA), the provisions of more universal concern are those defining which status changes may permit revocations and elections in accident, health and group-term life. Changes in Medicare or Medicaid status or a judgment, order or decree relating to marital or custody matters will also permit changes in cafeteria plan benefits. The permissible status changes are detailed in Temp. Regs. Sec. 1.125-4T(b) through (e), with Temp. Regs. Sec. 1.125-4T (f) through (i) reserved to cover change in status for other qualified benefits; significant coverage or cost changes; cessation of required contributions and requirements concerning Family and Medical Leave Act. For these areas, the taxpayer may still rely on the proposed regulations.

Under the new temporary regulations, a cafeteria plan may thus permit a revocation and election:

* that corresponds with special enrollment rights corresponding to HIPAA Section 9801(f) (Temp. Regs. Sec. 1.125-4T(b)).

* if, under the facts and circumstances, a change in status has occurred for accident or health coverage and group-term life, and the consistency requirements are satisfied (Temp. Pegs. Sec. 1.125-4T(c)). A change in status is limited to specific events. Events changing legal marital status include marriage, death of a spouse, divorce, legal separation or annulment. Events changing an employee's number of dependents include birth, adoption, placement for adoption or death of a dependent. Events changing employment status include the termination or commencement of employment by the employee, spouse or dependent; or a change in work schedule, including a reduction or increase in the hours of employment by the employee, spouse or dependent, whether the switch is between part- and full-time, strike or lock-out, or beginning or end of an unpaid leave of absence. A dependent ceasing to satisfy or satisfying requirements for unmarried dependents (such as attainment of age, student status or other similar circumstances provided in accident or health plans) also constitutes a change in status that permits a revocation and new election of such benefits. Similarly, a change in residence or work by the employee, spouse or dependent qualifies.

* pursuant to a judgment, decree or 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 ERISA) (Temp. Regs. Sec. 1.125-4T(d)).

* upon entitlement to Medicare or Medicaid (Temp. Regs. Sec. 1.125-4T(e)).

The HIPAA was enacted to improve health insurance availability for individuals who lose health care coverage as a result of changing or losing their jobs. With the changes made to cafeteria plans allowing revocations and elections conforming to the HIPAA, individuals may now revoke and make new elections following loss of other health coverage or the addition of a dependent, whether or not the change is a status change sanctioned elsewhere in the regulations, so that premium payments for the new coverage can be made on a pre-tax basis. While all other cafeteria plan elections operate to change coverage prospectively, those elections conforming with HIPAA special enrollments may cover costs retroactive to the date of coverage.

The consistency requirement of the new regulations contains an important exception for the Consilidated Onnibus Budget Reconicliation Act of 1985 (COBRA). Ordinarily, the new change-in-status rules applicable to health and accident coverage are limited to situations in which the employee, spouse or dependent gains or loses eligibility for such coverage under either the employee's cafeteria plan or under the spouse's or dependent's dent or health plan and the election corresponds with that gain or loss of coverage (Temp. Pegs. Sec. 1.125-4T(c)(3)). However, if the employee, spouse or dependent becomes eligible for continuation under either COBRA (Sec. 4980B) or a state version thereof, the employee may elect to increase payments under the cafeteria plan to pay for the continuation coverage. Thus, the employee now has the ability to use pre-tax dollars to pay for continuation coverage for a dependent no longer covered under a health plan or for his own COBRA coverage on termination (presumably from severance or final salary).

The change-in-status rules applicable to group-term life coverage are limited to a change in status in which any change in coverage is consistent with that changed status (Temp. Regs. Sec. 1.125-4T(c)(4)). Thus, the group-term life consistency requirements permit only an increase in coverage in the case of marriage or adoption, for example, and only a decrease in coverage in the case of divorce or death.

The existing proposed regulations were clear that Sec. 125 provided an exception to the doctrine of constructive receipt; revocations and elections not made in accordance with the guidelines would not be shielded from the doctrine by Sec. 125 (see, e.g., Prop. Regs. Sec. 1.125-1, Q&A-8 and -9). The exclusive provisions of the temporary regulations seem motivated by concern with limiting the potential for misuse of Sec. 125. While laudable in its goal of providing straightforward and administratively clear guidance, the exclusivity of the regulations has already raised taxpayer concern over common employment changes that would not permit revocations and elections, such as employees changing from hourly to salaried employment, a change from union to non-union contracts, or even the introduction of new benefits to an existing cafeteria plan in mid-year.

Despite taxpayer concern over the narrowness of these provisions, there has been little communication of such concerns directly with the Service. Although the comment period officially closed Feb. 5, 1998, it is believed the IRS will still accept comments that provide practical insight to the potential shortcomings of the regulations. With the benefit of such comments, perhaps the Service could modify the regulations to provide both employers and employees with the needed flexibility to make the changes necessary to accommodate real-world employment situations, while obtaining assurances that the doctrine of constructive receipt will not be eviscerated through Sec. 125.