The Basics of Cafeteria Plans

1. This Employer Webinar Series program is presented by Spencer Fane Britt & Browne LLPin conjunction with United Benefit Advisors

2. The Basics of Cafeteria Plans Presented by Kenneth A. Mason Lawrence Jenab

3. Presenters Ken Mason kmason@spencerfane.com 913-327-5138 Larry Jenab Ljenab@spencerfane.com 913-327-5125

4. What Is a Cafeteria Plan? • Choice between taxable benefits (e.g., cash) and non-taxable benefits (e.g., health care coverage) • Section 125 is the exclusive means by which employer can offer a choice without the choice itself resulting in taxable income to the employee (under “constructive receipt” doctrine) • A plan offering a choice between only taxable benefits (cash or paid time off), or only non-taxable benefits (e.g., a “flex plan”) is not a cafeteria plan

5. Qualified Benefits • Employer-provided health coverage • Health flexible spending account (“FSA”) • Dependent care FSA (“DCAP”) • Group-term life insurance • AD&D insurance • STD and LTD insurance • Adoption assistance • HSA contributions • 401(k) contributions • PTO

6. Impermissible (but Tax-Favored) Benefits • Scholarships • Educational assistance benefits • Dependent life insurance • Long-term care insurance • Fringe benefits • 403(b) deferrals • Heath reimbursement arrangement (“HRA”) • Medical savings account (“Archer MSA”)

7. Eligibility • Current employees • Former employees (so long as plan is not maintained predominantly for them) • But not: • Self-employed individuals • Sole proprietors • Partners • Directors • 2% shareholders of S-corporations

8. Written Plan Document • Must have a written plan document • Program must be operated in accordance with plan’s terms • Plan must be adopted and effective on or before first day of plan year • Any amendments must be made through formal written instrument

9. No Deferral of Compensation • Prohibition on deferred compensation does not apply to the following: • 401(k) contributions • HSA contributions • Grace period (up to 2 ½-months after end of plan year) • LTD policy • Advance payments for orthodontia • Salary reduction at end of one year to pay premiums for beginning of next year

10. Value to Employees • Advantages for employees: • No federal income tax • No FICA or Medicare tax • Generally, no state or city tax • Allows choice among benefits (or cash) • Increased take-home pay (vs. after-tax payment) • Disadvantages for employees: • Irrevocable elections • “Use-it-or-lose-it” rule • Possibly lower Social Security benefits

11. Value to Employers • Advantages for employers: • No FICA or Medicare tax • Cushion blow of premium increases (if cafeteria plan is introduced at the same time) • Non-comparable employer HSA contributions • Disadvantages for employers: • Set-up and administration costs • “Uniform coverage” rule (under health FSAs)

12. IRS Guidance • Final Regulations: • 1.125-3: Effect of FMLA leave • 1.125-4: Permitted Election Changes • Proposed Regulations: • 1.125-1: General Rules • 1.125-2: Special Election Rules • 1.125-5: Flexible Spending Accounts • 1.125-6: Claim Substantiation Rules • 1.125-7: Nondiscrimination Rules

13. IRS Guidance • Proposed Regulations were issued in 2007, incorporating decades of sporadic guidance • Expected to be finalized at any moment • May be relied upon in the interim

14. Election Rules • General Rule: Elections must be made – and irrevocable – before beginning of coverage period (generally, 12 months) • Several exceptions specified in IRS regulations • Exceptions apply only if also set forth in plan document

15. Exception: Change in Status Event • Change in status events • E.g. -- Birth, adoption, marriage, divorce, leave of absence, strike, lockout, change of worksite • Election change must be “consistent with” change in status • Limits who may add or drop coverage • Also requires timely request to change (though no specific deadline)

16. Exception: Special Enrollment • HIPAA special enrollment events • Substantial overlap with status changes • Two new events under “CHIPRA”: • Loss of eligibility for CHIP or Medicaid • Entitlement to premium subsidy under either program • May allow even unaffected dependents to be enrolled at same time (i.e., no “consistency” requirement) • Specific timeframes for enrollment • Generally must request change within 30 days • 60 days for CHIPRA events

17. Exceptions: Cost or Coverage Changes • Cost changes • If “insignificant,” may automatically adjust pre-tax premiums • If “significant,” may allow election change • Note: Not applicable to FSAs • Coverage changes • If “significant,” may allow move to other option • If change amounts to “loss of coverage,” may allow revocation of election • Note: Not applicable to FSAs

18. Example • Employer sponsors health plan with HMO and PPO options, along with an FSA. PPO has $500 annual deductible. • Employer amends PPO mid-year to raise deductible to $2000. • Employees in PPO option may elect to change to HMO option. • But may not drop coverage entirely, because not a “loss of coverage.” • And may not modify FSA elections, even though desirable to cover higher deductible.

19. Exception: Court Order • May allow employee to add dependent child or foster child if employee is ordered to cover child • May also allow employee to drop child from coverage if other parent is ordered to cover child (and in fact does so)

20. Exceptions: Medicare or Medicaid • Employee may be allowed to drop coverage for self or dependent upon becoming entitled to Medicare or Medicaid • Similarly, employee or dependent who loses Medicare or Medicaid coverage may be allowed to enroll in employer plan

21. Exceptions: 401(k) or HSA • If 401(k) contributions are made through a cafeteria plan (not recommended), 401(k) election change rules apply to that benefit • If HSA contributions are made through a cafeteria plan, employees must be allowed to change their HSA elections monthly • In neither case, however, may these election changes affect elections in effect with respect to other benefits (other than cash)

22. Other Enrollment Rules • “Negative” elections are permitted • May be “automatic” -- if enrolled in health plan, premiums must be pre-tax • May be “default” – if enrolled in health plan, premiums will be pre-tax, unless employee elects after-tax, instead • May be “evergreen” -- renewed from year to year unless changed (less common with FSAs, though also permissible) • New hires may be allowed to make initial elections within 30 days, retroactive to date of hire (although all pre-tax amounts must be taken from future pay) • Electronic elections are specifically authorized

23. Nondiscrimination: HCEs • Cafeteria plans may not discriminate in favor of “highly compensated individuals” as to eligibility, contributions, or benefits • “Highly compensated individuals” include • Officers, • 5% shareholders, and • Employees earning at least the HCE amount (currently, $110,000) in the current or prior year • Regulations incorporate certain Section 410(b) rules (applicable to retirement plans)

24. Nondiscrimination: Key Employees • “Key employees” may not receive more than 25% of the plan’s total non-taxable benefits • “Key Employees” include • 5% shareholders, • 1% shareholders earning more than $150,000, and • officers earning more than $160,000 • Particularly problematic for owners of small employers

25. Other Nondiscrimination Rules • “Safe harbor” rule for premium-only plans (need only satisfy eligibility nondiscrimination rule, regardless of actual utilization) • Safe harbor for health benefits -- but probably too complicated to use • All tests are to be conducted on last day of plan year

26. Effect of Discrimination • Under a discriminatory cafeteria plan, highly compensated individuals or key employees (as applicable) are taxed on the maximum taxable benefit they could have elected to receive • Generally, this will be their full salary, denying them any tax exclusion for health or other benefits

27. Flexible Spending Accounts • Health FSAs – may reimburse medical expenses, but not insurance premiums • Dependent Care Assistance FSAs – may reimburse dependent care expenses (for which no credit is claimed) • Adoption Assistance FSAs – may reimburse adoption expenses (for which no credit is claimed)

28. Special FSA Rules • All types of FSAs are subject to “use-it-or-lose-it” rule, although • Dependent care and adoption assistance FSAs may allow for “spend-down,” and • Any FSA may allow for 2 ½-month “grace period” • Health FSAs are subject to “uniform coverage” rule • All FSAs are subject to substantiation requirements

29. FMLA Leave Alternatives • Employees on FMLA leave must be allowed to continue health coverage at active-employee premium • And employees on unpaid FMLA leave must be allowed to revoke coverage (or receive it at employer’s cost, subject to employer’s later recapture of premiums) • Employer may waive employee premium payments while on unpaid leave (on a nondiscriminatory basis)

30. FMLA Leave Alternatives • Alternatively, employer may choose to allow employee premium payments under one of three options: • “Prepay” (generally pre-tax) • “Pay-as-you-go” (generally after-tax, unless employee receives vacation or sick pay while on leave) • “Catch-up” (generally pre-tax)

31. Special HSA Considerations • Payroll deduction HSA contributions may be made on a pre-tax basis only through a cafeteria plan • Although employees may claim a deduction for after-tax contributions, those contributions would be subject to FICA tax • This deduction is not subject to the 7.5% (soon to be 10%) AGI threshold • HSA election changes must be allowed on monthly basis (though they cannot affect other elections) • Exception to prohibition on deferred compensation (i.e., even though HSA account balances may be carried from year to year, and may be used to pay medical premiums)

32. Common Mistakes • Failure to have a plan document • Allowing impermissible mid-year election changes (especially for FSAs) • Violating the nondiscrimination rules (especially by small employers with owner or key employees) • Not allowing monthly HSA elections

33. Health Care Reform: FSAs, HSAs, HRAs • New restrictions on reimbursements from FSAs, HSAs, and HRAs • No reimbursements for OTC drugs (other than insulin) unless prescribed by a physician • Effective in 2011 • New limit on FSA contributions • Annual salary-deferral limit of $2,500 (indexed for inflation) • Effective in 2013 • Increased tax on nonqualified HSA distributions • Tax increases from 10% to 20% • For Archer MSAs, tax increases from 15% to 20% • Effective in 2011

34. Reform: Safe Harbor for “Simple” Plans • “Simple” cafeteria plans deemed to satisfy: • The cafeteria-plan nondiscrimination rules; and • The nondiscrimination rules for certain component benefits, such as: • Group-term life insurance • Self-insured medical coverage • Dependent care assistance • To be eligible, employer must: • Have employed average of 100 or fewer employees during past two years • Make minimum non-elective contribution for each eligible employee • Available in 2011

35. Reform: Health Care Exchanges • Affordable Care Act creates state clearinghouses (“exchanges”) for qualified health plans • General rule: qualified health plans cannot be offered through a cafeteria plan • Exception: certain small employers can offer employees the opportunity to enroll in a qualified health plan through an exchange

36. Questions and Answers

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