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Proposed cafeteria plan regulations.

On April 21, 2008, Tax Executives Institute submitted comments on the proposed cafeteria plan regulations issued under section 125 of the Internal Revenue Code. The comments were prepared under the aegis of TEI's Federal Tax Committee, whose chair is Carita Twinem of the Briggs & Stratton Corporation. Also contributing to the development of TEI's comments were Robert J. Birch of Wellmark, Inc., Chair of the Federal Tax Subcommittee on Employee Benefits and Payroll Taxes, Nancy C. Farahmand of JC Penney Company, Inc., and Michael J. Nesbitt of Paychex, Inc., and Beth P. Klimczak of Briggs & Stratton Corporation.

On August 6, 2007, the U.S. Department of Treasury and the Internal Revenue Service issued proposed regulations to provide guidance under section 125 of the Internal Revenue Code relating to cafeteria plans. (1) The proposed regulations were published in the August 6, 2007, issue of the Federal Register (72 F.R. 43937) and the September 24, 2007, issue of the Internal Revenue Bulletin (2007-39 I.R.B. 681). A hearing on the proposed regulations was held on November 15, 2007.


Tax Executives Institute is the preeminent global association of business tax executives with 7,000 members representing 3,200 of the leading corporations in the United States, Canada, Europe, and Asia. TEl represents a cross-section of the business community, and is dedicated to developing and effectively implementing sound tax policy, to promoting the uniform and equitable enforcement of the tax laws, and to reducing the cost and burden of administration and compliance to the benefit of taxpayers and government alike. As a professional association, TEl is firmly committed to maintaining a tax system that works--one that is administrable and with which taxpayers can comply in a cost-efficient manner.

Members of TEI are responsible for managing the tax affairs of their companies and must contend daily with the provisions of the tax law relating to the operation of business enterprises. We believe that the diversity and professional training of our members enable us to bring a balanced and practical perspective to the proposed regulations.

Executive Summary

A summary of TEI's recommended changes to the proposed section 125 cafeteria plan regulations is, as follows:

* Eliminate the statement in Prop. Reg. [section] 1.125-1(b)(1) that section 125 is the exclusive means of avoiding the constructive receipt doctrine when electing between taxable and nontaxable benefits.

* Ameliorate the harsh disqualification rule for operational plan violations.

* Avoid treating all cafeteria plan benefits as taxable to the participants where operational violations involve only a discrete part of a plan.

* Clarify when benefits "defer compensation" or operate to "defer compensation"; revise the timing for cash outs of accrued, unused leave.

* Permit certain election changes after the beginning of a plan year.

* Clarify the nondiscrimination rules.

* Establish a nationwide inventory information approval system reporting website for medical suppliers or defer the proposed effective date of Prop. Reg. [section] 1.125-6(h) in respect of debit card arrangements to plan years beginning January 1, 2010.

Section 125 Is Not the "Exclusive" Means of Avoiding the Constructive Receipt Doctrine

Prop. Reg. [section] 1.125-1(b)(1) states that "section 125 is the exclusive means by which an employer can offer employees an election between taxable and nontaxable benefits without the election itself resulting in gross income to the employee." (2) (Emphasis added.) TEI believes this statement is overbroad and should be removed from the regulations. Despite the recitation of selective portions of the legislative history of section 125 in the preamble, section 125 only applies to elections between cash and qualified benefits; it does not apply to elections between cash and nonqualified benefits, including "benefits" or compensation that might properly be understood as employee working conditions or reimbursable expenses. Hence, the statement in the regulations potentially distends the doctrine of constructive receipt by seeking to apply section 125 to circumstances far beyond the statute and the facts and circumstances to which the constructive receipt doctrine has historically been applied. Specifically, employment and pre-employment contract negotiations frequently encompass not only cash compensation, equity awards, and nontaxable benefits but also such matters as:

* departmental budgets (including the amount, manner, and scope of customer entertainment expenses; professional training for the executive and staff; organizational dues; and other forms of reimbursable employee expenses);

* administrative support (including salaries or a bonus pool for administrative support staff), office furnishings and decorations befitting the position (including computers or other electronic equipment); and

* allowances for temporary long-distance commuting or moving expenses.

In these negotiations, an employee or prospective employee often gives up rights to forms of or additional amounts of taxable compensation in exchange for potentially nontaxable compensation, benefits, reimbursable expenses, or guarantees relating to future working conditions. The constructive receipt doctrine has not previously reached such circumstances and section 125 should not apply to such negotiations.

In addition, in some industries (e.g., car repair, carpentry), employees must use certain tools and, depending on whether the employee or employer provides the tools, cash compensation is adjusted accordingly. The constructive receipt doctrine has not been extended to such situations and neither should the section 125 regulations. Hence, we urge the IRS to remove the sentence that section 125 is the "exclusive" means of avoiding constructive receipt.

Indeed, we recommend that the proposed regulation should be conformed to the preamble, which states that "except for an election made through a cafeteria plan that satisfies section 125 or another Code section (such as section 132(f)(4)), any opportunity to elect among taxable and nontaxable benefits results in inclusion of the taxable benefit regardless of what benefit is elected and when the election is made." (3) (Emphasis added.) Prop. Reg. [section] 1.125-1(b)(1) omits the reference to protection afforded by other Code sections, including the specific cross-reference to the "no constructive receipt" rule of section 132(f)(4) relating to qualified transportation fringe benefits. (4)

Plan Disqualification for Operational Violations is Unduly Harsh

Prop. Reg. [section] 1.125-1(c)(7)(i) states "if the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees' elections between taxable and nontaxable benefits result in gross income to the employees." (5) The proposed "all or nothing" disqualification rule for operational violations of the cafeteria plan has seemingly been incorporated from the qualified employee plan and trust rules of section 401, et seq.

The proposed plan disqualification rule--and the attendant income inclusion for all plan participants (ranging from dozens to potentially thousands)--is unduly harsh and should be ameliorated. Indeed, because of the Draconian consequences, revenue agents are often reluctant to impose a plan disqualification sanction for operational violations of qualified employee plans and trusts. To promote employer compliance without (or before) resorting to plan disqualification, TEI offers two recommendations.

1. Establish a participant-by-participant test for operational failures, similar to the regulations under section 409A.

Since there is no indication in section 125 that operational violations with respect to one employee (or even groups of employees where the administrator makes good faith or inadvertent errors) should affect other participants in the cafeteria plan making valid elections and otherwise complying with the rules, we recommend that the IRS adopt a different regulatory approach. As an alternative to the "all or nothing" rule of Prop. Reg. [section] 1.125-1(c)(7)(i), TEI recommends that the IRS adopt rules similar to those under section 409A. Specifically, Treas. Reg. [section] 1.409A-1(c)(1) states that "the requirements of section 409A are applied as if a separate plan or plans [were] maintained for each service provider." (6) Under this approach, errors by one employee (or by the administrator with respect to groups of employees) would not be imputed to other innocent participants. Since the cafeteria plan rules are intended to permit each employee to avoid the application of the constructive receipt doctrine because of the availability of an election between taxable and nontaxable compensation, the section 409A rules offer a model for addressing compliance at the individual employee level. As important, under TEI's recommended alternative approach an operational violation by an employee or by the administrator with respect to one employee or groups of employees would not affect other employees or the otherwise qualifying elections made by the employees.

2. Establish a voluntary correction program for cafeteria plans similar to the Employee Plans Compliance Resolution System (EPCRS).

Since employers are required to treat as taxable income (subject to payroll and income tax withholding) amounts that would otherwise qualify as nontaxable to the employee, there is a significant incentive for employers to comply with the section 125 rules. Even in the best administered plans, operational errors will occur--whether because of the sheer number and scope of transactions and covered employees or because of a good faith misinterpretation or misapplication of complex tax rules and equally complex provisions in benefit arrangements and contracts (such as medical or dental plan contracts or insurance agreements) that are administered in connection with the plan. Hence, if the plan disqualification rule is retained, we encourage the IRS to establish a voluntary correction program for cafeteria plans similar to the Employee Plans Compliance Resolution System (EPCRS) for qualified employee plans and trusts. The disproportionate consequences of plan disqualification for violations are too harsh to be appropriate in any but the most egregious circumstances, such as willful noncompliance. Even where repeated violations occur, the errors may be inadvertent (7) or attributable to misunderstanding. We urge the IRS to reconsider its approach to addressing operational failures of cafeteria plans.

Violations of the Flexible Spending Arrangement (FSA) Rules Should Not Affect the Treatment of Other Cafeteria Plan Benefits and Vice Versa

Prop. Reg. [section] 1.125-5 sets forth detailed rules governing the treatment of flexible spending arrangements (FSAs). Where a cafeteria plan offers an FSA among the benefit choices, the FSA rules must be incorporated in the written plan document and the FSA and plan must operate in compliance with those rules.

TEI does not believe that an operational violation of one part of a cafeteria plan should necessarily cause a loss of the constructive receipt protection for benefits offered under other parts of the plan or to innocent employees. For example, if the cafeteria plan administrator were to consistently permit reimbursement of nonqualified medical expenses under a health FSA, the violations should potentially result only in the taxation of the erroneous reimbursements from the health FSA. The violations should not affect other qualified benefits that might be offered under the plan such as medical, disability, or life insurance coverages. As another example, violations of the rules governing health FSAs should not cause a loss of protection from the constructive receipt rule for dependent care FSAs (and vice versa). We recommend that the IRS provide rules that permit the operational compliance of the various components of the cafeteria plan to be satisfied on a separate basis with respect to each of the different forms of benefits offered under the plan. In the absence of such a rule (e.g., because the IRS deems such a rule too burdensome to administer effectively), a voluntary correction program similar to the EPCRS would be helpful in ensuring that employers' good faith errors are corrected in a timely fashion.

Deferral of Compensation to a Subsequent Year

Prop. Reg. [section] 1.125-1(b)(5) states "[e]xcept as provided in paragraph (o) of this section, in order for a plan to be a cafeteria plan, the qualified benefits and permitted taxable benefits offered through the cafeteria plan must not defer compensation. For example, a cafeteria plan may not provide for retirement health benefits for current employees beyond the current plan year or group-term life insurance with a permanent benefit, as defined under [section] 1.79-0." (8) We have two recommendations relating to the rules proscribing deferral of compensation.

1. Provide a definition for deferred compensation to clarify when benefits defer compensation or operate to defer compensation. The proposed regulations do not define the term deferred compensation or provide guidance on what it means to defer compensation. Instead the regulations provide descriptions and examples of permitted and impermissible benefit features. Since the examples and descriptions cannot possibly address all current and especially future forms of benefit features, TEI recommends that the regulations define the term "deferred compensation." Without a definition, the development of new benefit forms may be impeded because employers will be required to seek guidance from the IRS in respect of every new feature or payment alternative that might be devised and viewed as a way to "defer compensation." By providing a definition, employers will be able to design and amend their cafeteria plans to avoid providing deferred compensation.

2. Revise the timing of the cash-out rule for paid time off. Prop. Reg. [section] 1.125-1(o)(4) provides the general rules for including paid time off (whether in the form of vacation, sick, or personal days) as a taxable benefit in a cafeteria plan. In addition, under Prop. Reg. [section] 1.125-1(o)(4)(iii)(A), a plan does not permit the deferral of compensation merely because the plan provides for cash outs of unused paid time off. To satisfy the prohibition against deferral of compensation, however, the employee "must receive the cash on or before the last day of the cafeteria plan's year to which the elective contributions used to purchase the unused elective paid time off relate." (9) Most employers will be unable to determine and pay the proper amount of unused leave as of the last day of the plan year, especially if the plan year is a calendar year. Specifically, many employees take leave during the holiday period in the final week or two of the calendar year including December 31--likely the last day of many employers' plan years. Until such leave is used, the employer will be unable to determine the proper amount to cash out. TEI recommends that employers be permitted to pay the balance of unused leave with the first payroll period following the end of the year, but no later than say, 15 days following the end of the plan year. If TEI's recommendation is deemed to result in "deferred compensation," an alternative (or companion) rule might be to permit the deferred payment as long as the employer includes the amount of such cashed-out leave in the Form W-2 for the employee for the plan year to which the cash out relates. (10)

Changes in Elections

Prop. Reg. [section] 1.125-2 provides rules governing the time and manner for employees to make, change, or revoke valid elections. We offer the following recommendations and comments in respect of those rules.

1. Clarify that elections based on a mistake of fact can be corrected after the beginning of the plan year. The proposed regulations do not address whether an erroneous benefit election, especially those based on a mistake of fact, can be corrected after the beginning of the plan year. Many employers and plan administrators have interpreted section 125 and the regulations, including the previous proposed regulations, to permit employees to revoke or amend cafeteria plan elections after the plan year begins where the election is based on a mistake of fact. For example, assume a participant who has no children under the age of thirteen (or any other dependents incapable of self-care) elects to make a salary reduction contribution to a dependent care FSA for the plan year and the participant discovers after the beginning of the plan year that he was ineligible to contribute to or be reimbursed from a dependent care FSA. Most plan administrators have permitted the participant to revoke the election retroactively to the beginning of the plan year and have treated the elective amounts as fully taxable to the participant. TEI recommends that the regulations clarify that an election based on a mistake in fact can be revoked and the participant made whole (with a refund of previously deferred amounts) as long as the amounts previously deferred are treated as fully taxable to the participant.

2. Clarify that erroneous FSA elections can be corrected within a reasonable period after the beginning of the plan year. The proposed regulations also do not address whether a plan administrator may permit a participant to correct other erroneous elections, including typographical or scrivener errors, after the beginning of the plan year. The obvious examples are elections--whether submitted electronically or on paper form--by FSA participants to contribute $500 (or $5,000) to a health FSA where the participants intended to contribute $5,000 (or $500). When completing an annual election form, participants may inadvertently omit (or add) a zero on the wrong side of the decimal point. Participants often do not discover such mistakes until the first payroll period following the beginning of the plan year when the amount withheld from the paycheck differs from the participants' expectations. TEI recommends that the regulations afford participants an opportunity to make corrections to erroneous elections during the plan year without losing the benefit of the protection from constructive receipt. A reasonable correction period might be, say, 30 calendar days following the first payroll payment date occurring within the plan year.

Nondiscrimination Rules

1. Written Document. Prop. Reg. [section] 1.125-1-(c)(1) sets forth the requirements for a written plan and includes a statement that the "terms of the plan must apply uniformly to all plan participants." (11) In light of the rules in Prop. Reg. [section] 1.125-7, which prohibit cafeteria plans from discriminating in favor of highly compensated individuals in respect of (1) eligibility requirements and (2) contributions and benefits, it is unclear what the purpose of that statement is or how a plan will be tested to determine whether it applies "uniformly" to all participants. We recommend that the sentence be deleted from Prop. Reg. [section] 1.125-1(c)(1).

2. Includible Compensation. Prop. Reg. [section] 1.125-7(a)(2) defines compensation for purposes of nondiscrimination testing by cross reference to section 415(c)(3). Treas. Reg. [section] 1.415(c)-2(f), in turn, incorporates the limit on compensation prescribed by section 401(a)(17). By capping the includible compensation amount for highly compensated participants, the cafeteria plan rules will increase the percentage of benefits and contributions allocable to the highly compensated participants and make it more likely the cafeteria plan will be deemed discriminatory. There is nothing in section 125 or the legislative history to suggest that Congress intended the section 401(a)(17) limit to apply to cafeteria plans. TEI recommends that the definition of compensation be revised to eliminate the implication.

Debit Cards

Prop. Reg. [section] 1.125-6(c) sets forth rules governing the use of debit cards for substantiating, paying, and reimbursing expenses for section 213(d) medical care as well as rules under which an FSA may pay or reimburse dependent care expenses. The proposed rules governing medical care payments and reimbursements synthesize and summarize guidance previously issued in revenue rulings, revenue procedures, and notices. Prop. Reg. [section] 1.125-6(d)(6) states that the employer is responsible for substantiating all claims paid with the debit card, including amounts paid to medical care providers, drug store and pharmacies (as long as 90 percent of the drug store or pharmacy gross receipts consist of items that qualify as section 213(d) expenses), and other stores that maintain an inventory information approval system (IIAS). An IIAS that meets all of the requirements in Prop. Reg. [section] 1.125-6(f) will satisfy the employer's substantiation obligations without need for the employee to submit a receipt or for the employer to review additional documentation.

It is unclear how large employers with employees across the country can ensure full compliance with the substantiation requirements by the proposed effective date of January 1, 2009. Indeed, it will be nearly impossible for large employers to contact every possible medical supplier in every community where there are employees in order to vet the list of products for compliance with section 213(d). There are two possible technological solutions. First, the IRS could establish a nationwide IIAS database where all potential suppliers can post their list of eligible products and the employers can confirm which suppliers will be eligible to participate in the employer's plan. Alternatively, the suppliers might be required to obtain certification from the IRS that their IIAS includes only qualifying products. Employers would then be able to rely on the suppliers' certifications for the automatic substantiation. To the extent neither proposal is acceptable, we recommend that the proposed effective date in Prop. Reg. [section] 1.125-6(h) for debit cards be deferred to plan years beginning January 1, 2010, in order to give large employers time to vet their employees' medical suppliers. The current rules governing the use of debit cards would continue to apply until then.

Finally, although we appreciate the opportunity for notice and comment that proposed regulations afford to taxpayers, the technology for payment systems is evolving at a rapid pace. To expedite the issuance of future guidance, the IRS may wish to minimize the requirements set forth in Prop. Reg. [section] 1.125-6(c)-(g) and instead provide file bulk of the debit card guidance in a revenue procedure or notice that can be updated more easily to address the evolution of payment systems.


Tax Executives Institute appreciates this opportunity to present its views on the proposed regulations relating to the cafeteria plans. If you have any questions about the submission, please do not hesitate to contact Carita R. Twinem, chair of TEI's Federal Tax Committee, at 414.256.5141 (or twinem., or Jeffery P. Rasmussen of the Institute's legal staff at 202.638.5601 (or

(1.) The Notice also withdraws notices of proposed rulemaking issued May 7, 1984; March 7, 1989; November 7, 1997; and March 23, 2000.

(2.) 2007-39 I.R.B. 681, 691.

(3.) 2007-39 I.R.B. 681, 682.

(4.) Section 132(f)(4), which is entitled "No Constructive Receipt," provides "[n]o amount shall be included in the gross income of an employee solely because the employee may choose between any qualified transportation fringe and compensation which would otherwise be includible in gross income of such employee." Hence, section 132(f)(4) on its face rebuts the proposed regulations' assertion that section 125 is the exclusive means to avoid constructive receipt where a choice over the form and timing of compensation is available.

(5.) 2007-39 I.R.B. 681, 693.

(6.) T.D. 9321 (April 17, 2007).

(7.) For example, the due date for submitting new employee elections can easily be missed. Similarly, plan administrators may permit mid-year election changes that do not satisfy the change-in-status rules of Treas. Reg. [section] 1.125-4, especially the consistency rule in Treas. Reg. [section] 1.125-4(c)(3).

(8.) 2007-39 I.R.B. 681, 692.

(9.) 2007-39 I.R.B. 681, 698 (emphasis added).

(10.) At a minimum, the rules should permit employers with payroll periods that straddle a plan year end (e.g., weekly or biweekly pay periods beginning on or before and ending after December 31) to cash out accrued leave with the next regularly scheduled payroll date. Otherwise, such employers will be required to process a special payroll to cash out the accrued leave. That said, TEI believes the better approach is to take account of administrative practices and slightly relax the "no deferral" rule for all employers.

(11.) 2007-39 I.R.B. 681, 712. (Emphasis added.)
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Publication:Tax Executive
Date:May 1, 2008
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