Comments on proposed regulations under Section 125 relating to cafeteria plans.

Comments on Proposed Regulations Under Section 125 Relating to Cafeteria Plans 

On March 2, 1989, the Internal Revenue Service issued proposed regulations under sections 89 and 125 of the Internal Revenue Code of 1986, relating to the nondiscrimination and qualification requirements for certain employee benefit plans. The proposed regulations (EE-130-86) were published in the Federal Register on March 7, 1989 (54 Fed. Reg. 9460), and reprinted in the March 27, 1989, issue of the Internal Revenue Bulletin, 1989-13 I.R.B. 9.

The proposed regulations update previously proposed regulations published on May 7, 1984 (49 Fed. Reg. 19321), and amended on December 31, 1984 (49 Fed Reg. 50733).

For simplicity's sake, the 1989 proposed regulations are referred to in the following comments as the "proposed regulations" and the 1984 proposed regulations are referred to as the "1984 regulations." Specific provisions are cited as "Prop. Reg. (date)."

1. Prop. Reg. 1.125-2, Q&A 1:

Effective Date

Prop. Reg. 1.125-2, Q&A 1 provides that Q&A 2 through Q&A 6 are effective in accordance with the effective date provisions of section 89 (generally plan years beginning after December 31, 1988). TEI strongly recommends that the proposed regulations should be applied on a prospective-only basis.

Many calendar-year employers generally begin drafting employee communications no later than the last quarter of the preceding plan year in order to permit their employees to make timely and informed elections by the end of the preceding year. For example, with respect to a plan-year beginning January 1, 1989, employers would strive to release employee information no later than September 30, 1988. Retroactive changes made during the plan year not only significantly increase the cost of maintaining the plan, but also cause confusion and misconceptions among the employees. TEI strongly recommends that the proposed regulations be effective only with respect to plan years beginning after December 31, 1989.

2. Prop. Reg. 1.125-2, Q&A-5:

Cash-Out of Unused Benefits

Q&A-5 of Prop. Reg. 1.125-2 generally provides that a cafeteria plan may permit a participant with unused elective vacation days to receive the value of such unused days in cash on or before the last day of the plan year.

The new provision addresses concerns expressed by many employers which were reluctant to offer vacation benefits under the 1984 regulations (which did not allow the cash-out of unused elective vacation days). See Prop. Reg. 1.125-1, Q&A-7 (1984). Under the previous rule, employers faced the possibility that employees could be required to forfeit benefits because of scheduling conflicts and time pressures imposed on the employer at year-end.

TEI applauds the flexibility offered by Prop. Reg. 1.125-2, Q&A-5 (1989), and recommends that similar cash-out provisions be adopted with respect to other unused benefits (such as health care and dependent care benefits). (1) Such a provision would not only benefit employees, but might well enhance revenue by converting unused benefits into taxable compensation.

3. Prop. Reg. 1.125-2, Q&A-6:

Revocation of Elections

a. Significant Cost or Coverage Changes. Prop. Reg. 1.125-2, Q&A-6(b)(2) (1989) states that, if the health coverage provided by an independent third-party is significantly curtailed or ceases, the plan may permit affected participants to revoke their election and receive coverage under another health plan with similar coverage. The proposed regulations make no attempt to define what constitutes a significant curtailment in coverage.

TEI believes that requiring participants to elect "similar coverage" provided by the employer unnecessarily constrains the employee. Specifically, an employee who elected to receive health benefits from a specific health maintenance organization (HMO) that subsequently dissolves may find participation in another HMO unsuitable for his family needs (e.g., because of location or the absence of specific medical care). TEI therefore recommends that the "similar coverage" provision be expanded to include "any coverage" offered by the employer.

We submit there is no policy justification for limiting the revocation provision to plans that are provided by an independent third party and note that the preamble offers no explanation for this limitation. We also recommend that the proposed regulations be expanded to include self-insured health plans.

Guidance should also be given concerning what constitutes a significant curtailment in coverage or a significant change in costs. In this regard, TEI recommends that specific examples be provided discussing such factors as an increase in premium costs absorbed by the employee and changes in the deductible, co-payment percentages, annual out-of-pocket limitations, and life-time maximum amounts.

b. Cessation of Required Contributions. Under Prop. Reg. 1.125-2(e) (1989), a cafeteria plan may provide that a benefit will cease if an employee fails to make the required premium payments. The plan must provide that the employee is prohibited from making a new benefit election for the remaining portion of the coverage.

TEI recommends that the final regulations contain a hardship exception to rules governing the cessation of required contributions. Thus, if an employee terminates premium payments because of hardship reasons, he will be allowed to reactivate his coverage under the plan (even if within the same plan year) once the hardship has ceased.

4. Prop. Reg. 1.125-2, Q&A-7:

Flexible Spending

Arrangements

a. Generally. Cafeteria plans often contain flexible spending arrangements (FSAs) for the reimbursement of specific expenses incurred by a participant during the year. Prop. Reg. 1.125-2, Q&A-7(c) (1989) defines an FSA as a benefit that provides employees with coverage under which certain expenses may be reimbursed and the maximum amount of the reimbursement is not substantially in excess of the total premium (including employee and employer contributions) for such participant's coverage. Prop. Reg. 1.125-2, Q&A-7(a) (1989) further provides that health FSAs --

must conform to the generally applicable rules under sections 105 and 106 in order for the coverage and reimbursements under such plans to qualify for tax-favored treatment under such sections. Thus, health FSAs must qualify as accident or health plans. This means that, in general, while the health coverage under the FSA need not be provided through a commercial insurance contract, health FSAs must exhibit the risk-shifting and risk-distribution characteristics of insurance. . . . A health FSA will not qualify for tax-favored treatment under sections 105 and 106 of the Code if the effect of the reimbursement arrangement eliminates all, or substantially all, risk of loss to the employer maintaining the plan or other insurer.

TEI objects to Q&A-7 because it imposes requirements on FSAs far beyond those required by the Code. Specifically, neither section 105 nor 106 requires that the risk-shifting or risk-distribution characteristics of insurance exist in order for a plan to qualify as an "accident or health plan." In fact, section 105 expressly deems plans which do not exhibit risk-shifting or risk-distribution aspects to qualify for tax-favored treatment. Section 105(e) provides that amounts received under an accident or health plan for employees "shall be treated as amounts received through accident or health insurance." (Emphasis added.) Treas. Reg. 1.105-5(a) emphasizes this treatment by defining an accident or health plan as "an arrangement for the payment of amounts to employees in the event of personal injuries or sickness. . . . [A]n accident or health plan may be either insured or noninsured."

Thus, neither the statute nor the regulations require such plans to exhibit risk-shifting or risk-distribution characteristics. Rather, the congressional intent to exclude from taxation medical benefits received by the employee -- from whatever source -- is clear. See H.R. Rep. No. 1337, 83d Cong., 2d Sess 15 (1954); S. Rep. No. 1622, 83d Cong., 2d Sess. 15-16 (1954).

Section 106 of the Code similarly includes no risk-shifting or risk-distribution requirement. That section merely provides that an employee's gross income does not include employer-provided coverage -- such as contributions to a health FSA (Prop. Reg. 1.125-1, Q&A-6 (1984)) -- under an accident or health plan. Thus, neither section 105 nor 106 supports the risk-shifting requirement of the proposed regulations. (2)

The potential negative effect of Q&A-7 cannot be overstated. Under the proposed regulations, if an employee elects to contribute $5,000 to his health care fund through salary reduction over the course of the year, the employer must make the entire $5,000 available to the employee at the beginning of the year (and prior to the accumulation of funds in that employee's account). The employer has no mechanism available, however, to recover any disbursed funds from the employee upon his separation from service. The cost associated with shifting this risk to the employer will undoubtedly force many employers to reevaluate the viability of offering health benefits through a cafeteria plan. (3)

Moreover, Q&A-7 seems to require that an employee be permitted to continue paying premiums after a termination. Further guidance is needed on the mandatory nature of this provision and its interaction with the Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA).

In sum, Prop. Reg. 1.125-2, Q&A-7 (1989) represents a radical departure from the congressional intent engendered by sections 105 and 106. (4) TEI submits that the provision should be deleted in its entirety.

c. Effective Date. Q&A-7 is generally effective with respect to plan years beginning after December 31, 1989. Prop. Reg. 1.125-2, Q&A-1 (1989). If retained, Q&A-7's risk-shifting requirements will force employers to review the continued feasibility of their health FSAs. Given the proposed nature of the regulations and the need to communicate plan amendments to participants as early as possible, (5) additional time is needed to allow employers and plan participants to make informed decisions. TEI requests that Q&A-7 be made effective with respect to plan years beginning after December 31, 1990.

CONCLUSION

Tax Executives Institute appreciates this opportunity to present our views on the proposed regulations relating to cafeteria plans. If you have any questions, please do not hesitate to call Lester D. Ezrati, chair of TEI's Federal Tax Committee, at [phone] or the Institute's professional staf (Timothy J. McCormally or Mary L. Fahey) at [phone].

(1) Participants could also be permitted to rollover unused benefits into a section 401(k) plan.

(2) Significantly, the IRS cites only the prior 1984 regulations as support for its position. See 1989-13 I.R.B. at 14. This risk-shifting requirement has been subject to criticism. See Raish, 397 T.M., Cafeteria Plans A20-A21.

(3) Further, by shifting costs to employers, the proposed regulations undermine the cost-containment goal of many employers that offer health benefits through a cafeteria plan.

(4) Moreover, Q&A-17 and Q&A-18 of the 1984 regulations clearly provide that reimbursements for medical or dependent care may be limited under a cafeteria plan. Permitting an employer to limit his losses, while requiring him to retain the risk of loss, seems inconsistent as a policy matter.

(5) Employees participating in calendar-year plans must generally make FSA elections in October or early November of the year preceding the plan year.