Cafeteria Plans

A section 125 or “cafeteria” plan is a type of employee benefit plan pursuant to Section 125 of the Internal Revenue Code (the “Code”). Its name comes from the earliest such plans that allowed employees to choose between different types of benefits, similar to a cafeteria. All cafeteria plans must offer employees a choice between cash and qualified benefits. Though some cafeteria plans offer an explicit choice of cash or benefits, most today are operated through a “salary reduction agreement”, which is a payroll deduction. Deductions under such agreements are often called pre-tax deductions and are not considered wages for federal income tax purposes if the deductions are made through a written cafeteria plan.

How It Works

A cafeteria plan allows employees to withhold a portion of their pre-tax salary to cover certain “qualified benefits.” This pre-tax option benefits employees by reducing their taxable income and it benefits employers by eliminating payment of FICA and workers’ compensation premiums on those dollars.

• Salary reduction contributions are not actually or constructively received by the participant. Therefore, those contributions are not considered wages for federal income tax purposes.
• In addition, those sums generally are not subject to FICA and FUTA.

Qualified Benefits

Under a cafeteria plan, employees can take advantage of a variety of qualified benefits. The three most common benefits are:

1. Pre-tax health insurance premium deductions, also known as a Premium Only Plan (POP).

2. Health flexible spending accounts (Health FSAs) allow participants to pay unreimbursed qualified medical expenses with pre-tax dollars.

• Please note that a Health FSA may also be considered a health plan subject to ERISA (for private sector employers) and the ACA.

3. Dependent care flexible spending accounts which allow participants to pay certain childcare expenses with pre-tax dollars.

Employers can also offer the option to contribute to an individual health savings account (HSA) through the cafeteria plan, allowing employees to make contributions to their HSA accounts on a pre-tax basis.

Other qualified benefits include group term life insurance; adoption assistance; long-term or short-term disability coverage; coverage under other arrangements that qualify as accident or health plans under the Code (i.e., employer-sponsored group dental or vision coverage and purchase or sale of paid time off (PTO) such as vacation, sick or personal days).

Employee contributions to the cafeteria plan are usually made pursuant to salary reduction agreements between the employer and the employee in which the employee agrees to contribute a portion of his or her salary on a pre-tax basis to pay for the qualified benefits.  These contributions cannot be changed during the plan year except in defined circumstances.

Who May Receive Benefits

Participants in a cafeteria plan must be employees, although the plan may reimburse expenses paid on behalf of individuals who qualify as tax dependents under Section 152 of the Internal Revenue Code.

• Employees include leased employees, statutory employees and former employees.
• Partners in a partnership and 2% shareholders in a subchapter S Corporation are not eligible to participate.

Cafeteria Plan Document

Employers must have a plan document for cafeteria plans that is adopted prior to the effective date of the plan, even if it is a premium only arrangement.

This document outlines specific details, such as:

• a description of the employee benefits that are covered under the plan
• participation rules
• annual limits
• election procedures
• eligibility
• employer contributions
• definition of the plan year
• adoption of IRS change of status rules
• irrevocability of elections

Filing Requirements

If an employer only has a Premium Only Plan, it is not required to file Form 5500.

However, if an employer has a health FSA component in its cafeteria plan, it is required under Department of Labor regulations to file a Form 5500 for that plan, because it is an ERISA welfare benefit plan (unless otherwise exempt).

Please see the Form 5500 compliance instructions for more information, including exemptions, or contact the U.S. Department of Labor.

Definition of Spouse

The term “spouse” has been changed under federal law to include an individual married to a person of the same sex, as a result of the Supreme Court’s decision in United States v. Windsor. As such, a cafeteria plan may permit a participant’s FSA, including a health, dependent care, or adoption assistance FSA, to reimburse covered expenses of the participant’s same-sex spouse or the same-sex spouse’s dependent that were incurred during a period beginning on a date that is no earlier than (a) the beginning of the cafeteria plan year that includes June 26, 2013 or (b) the date of marriage, if later.

Cafeteria Plans and HSAs

Individual HSAs must be included in the Cafeteria Plan if the employer allows employees to make HSA contributions on a pre-tax basis through salary reduction.

If the HSA is not part of a cafeteria plan, an employee’s contributions made after tax can still be deducted on their tax return.

Employers should remember that an individual is not eligible for an HSA if they also have a “General Purpose” health FSA, i.e. one that reimburses all qualified medical expenses.  In addition, if the general purpose health FSA has a grace period that extends into the following plan year, an individual who participated in the general purpose health FSA for the immediately preceding cafeteria plan year and who is covered by the grace period is not eligible to contribute to an HSA until the first day of the first month following the end of the grace period.

Although employees participating in a “General Purpose” Health FSA cannot contribute to an HSA, an individual may contribute to an HSA while they are covered under “specific types” of health FSAs.  These include:

• Limited Purpose Health FSA – which pays or reimburses expenses only for preventive care and “permitted coverage” (e.g. dental care and vision care).
• Post Deductible Health FSA – which pays or reimburses qualified medical expenses only if incurred after the minimum annual deductible for the high deductible health plan (HDHP) is satisfied.

Simple Cafeteria Plans

The ACA included a provision creating “simple cafeteria plans” for small businesses.  Simple cafeteria plans are treated as meeting nondiscrimination requirements applicable to cafeteria plans if the plan is designed in a manner that meets minimum eligibility, participation, and contribution requirements established by statute.

An employer is eligible to implement a simple cafeteria plan if, during either of the preceding two years, the business employed 100 or fewer employees on average (based on business days). For a new business, eligibility is based on the number of employees the business is reasonably expected to employ. Businesses maintaining a simple cafeteria plan that grow beyond 100 employees can continue to maintain the simple arrangement until they have exceeded an average of 200 or more employees during a preceding year.  For more information, see the IRS Publication 15-B, Employer’s Guide to Fringe Benefits.

Revocation For Employees Whose Hours Are Reduced or Who Enroll in a Qualified Health Plan

A cafeteria plan may allow an employee to prospectively revoke an election of coverage under a group health plan that is not a health FSA and that provides minimum essential coverage provided the following conditions are met:

Conditions for revocation due to reduction in hours of service

(1)    The employee has been in an employment status under which the employee was reasonably expected to average at least 30 hours of service per week and there is a change in that employee’s status so that the employee will reasonably be expected to average less than 30 hours of service per week after the change, even if that reduction does not result in the employee ceasing to be eligible under the group health plan; and

(2)    The revocation of the election of coverage under the group health plan corresponds to the intended enrollment of the employee, and any related individuals who cease coverage due to the revocation, in another plan that provides minimum essential coverage with the new coverage effective no later than the first day of the second month following the month that includes the date the original coverage is revoked.

A cafeteria plan may rely on the reasonable representation of an employee who is reasonably expected to have an average of less than 30 hours of service per week for future periods that the employee and related individuals have enrolled or intend to enroll in another plan that provides minimum essential coverage for new coverage that is effective no later than the first day of the second month following the month that includes the date the original coverage is revoked.

Conditions for revocation due to enrollment in a Qualified Health Plan

(1)    The employee is eligible for a Special Enrollment Period to enroll in a Qualified Health Plan through a Marketplace pursuant to guidance issued by the Department of Health and Human Services and any other applicable guidance, or the employee seeks to enroll in a Qualified Health Plan through a Marketplace during the Marketplace’s annual open enrollment period; and

(2)    The revocation of the election of coverage under the group health plan corresponds to the intended enrollment of the employee and any related individuals who cease coverage due to the revocation in a Qualified Health Plan through a Marketplace for new coverage that is effective beginning no later than the day immediately following the last day of the original coverage that is revoked.

A cafeteria plan may rely on the reasonable representation of an employee who has an enrollment opportunity for a Qualified Health Plan through a Marketplace that the employee and related individuals have enrolled or intend to enroll in a Qualified Health Plan for new coverage that is effective beginning no later than the day immediately following the last day of the original coverage that is revoked.

The Children’s Health Insurance Program Reauthorization Act of 2009 (CHIPRA)

Under this Act, group health plans and group health insurance issuers must offer new special enrollment opportunities. Effective April 1, 2009, employees or dependents must be allowed to enroll mid-year if they lose Medicaid or Children’s Health Insurance Program (formerly known as the State Children’s Health Insurance Program or SCHIP) coverage by losing eligibility or become eligible for Medicaid or CHIP assistance with group health plan premiums. For more information, see the CHIPRA compliance activity. Cafeteria plans that recognize eligibility for HIPAA special enrollment as a status change (allowing midyear elections) should be amended to reflect the new CHIPRA special enrollment right and the 60-day period to request plan enrollment.

Health FSAs

Annual Maximum

Each year the maximum FSA salary reduction is indexed to the Consumer Price Index and health FSA salary reductions are limited to a maximum annual limit. It is important to note that the annual maximum applies to employee salary reduction contributions only. It does not apply to non-elective contributions made by an employer to a health FSA, sometimes called flex credits. However, if an employer provides flex credits that employees may elect to receive as cash or as a taxable benefit, those flex credits are treated as salary reduction contributions that are subject to the maximum limit. See the compliance activity, reference material or IRS Notice 2012-40 for additional information on implementation of the Health FSA annual maximum.

Modified “Use-or-Lose” Rule (Carryover)

The IRS now permits Sec. 125 cafeteria plans to allow plan participants to carry over up to $500 of their unused health FSA balances remaining at the end of a plan year to the new plan year if:

• The plan does not also incorporate the grace period rule;
• The same carryover limit applies to all plan participants;
• The carryover amount is only used to pay for qualified medical expenses (as allowed under the plan) in the new plan year.

In addition, the carryover of up to $500 does not count against or otherwise affect the indexed annual salary reduction limit (and any non-elective employer flex credits) applicable to each plan year. 

Carryover Amount

Although the maximum unused amount allowed to be carried over in any plan year is $500, the plan may specify a lower amount as the permissible maximum (and the plan sponsor has the option of not permitting any carryover at all).

The amount that may be carried over to the following plan year is equal to the lesser of:

1. Any unused amounts from the immediately preceding plan year; or
2. $500 (or a lower amount specified in the plan).

Any unused amount in excess of $500 (or a lower amount specified in the plan) that remains unused as of the end of the plan year is forfeited.

Any unused amounts from the prior plan year that are used to reimburse a current year expense:

• Reduce the amount available to pay prior plan year expenses during the run-out period;
• Must be counted against the permitted carryover of up to $500; and,
• Cannot exceed the permitted carryover.

Run-Out Claims

The carryover option does not affect the ability of a health FSA to provide for the payment of expenses incurred in one plan year during a permitted run-out period at the beginning of the following plan year.

Therefore, a participant’s unused health FSA balance at the end of the prior plan year may be used for:

1. Expenses incurred in the prior plan year, but only if claimed during the plan’s run-out period that begins at the end of the prior plan year (in effect, retroactively reducing the unused amount as of the end of the prior plan year); or,
2. Expenses that are incurred at any time in the current plan year.

Carryover Amendments

An amendment setting forth the carryover provision must be adopted on or before the last day of the plan year from which amounts may be carried over.

• The amendment may be effective retroactively to the first day of that plan year.
• Plans that have a grace period that wish to adopt the carryover provision must also be amended to eliminate the grace period provision by no later than the end of the plan year from which amounts may be carried over.
• Participants must be notified of the addition of the permitted carryover.

Health FSA Carryover ($500 Limit) Examples

Example 1.

Employer sponsors a Sec. 125 cafeteria plan and health FSA with a calendar plan year, an annual run-out period from January 1 through March 31 in which participants can submit claims for expenses incurred during the preceding plan year, and an annual open enrollment season in November in which participants elect a salary reduction amount (not to exceed $2,500) for the following plan year. The plan is timely amended to provide for a carryover that allows all participants to apply up to $500 of unused health FSA amounts remaining at the end of the run-out period to the health FSA for expenses incurred at any time during that plan year. The plan does not provide for a grace period with respect to the health FSA. The plan also does not provide for non-elective employer flex credits.

In November 2014, Participant A elects a salary reduction amount of $2,500 for 2015. By December 31, 2014, A’s unused amount from the 2014 plan year is $800. On February 1, 2015, A submits claims and is reimbursed with respect to $350 of expenses incurred during the 2014 plan year, leaving a carryover on March 31, 2015 (the end of the run-out period) of $450 of unused health FSA amounts from 2014. The $450 amount is not forfeited; instead, it is carried over to 2015 and available to pay claims incurred in that year so that $2,950 (that is, $2,500 + $450) is available to pay claims incurred in 2015.

A incurs and submits claims for expenses of $2,700 during the month of July 2015, and does not submit any other claims during 2015. A is reimbursed with respect to the $2,700 claim, leaving $250 as a potential unused amount from 2015 (depending upon whether A submits claims during the 2015 run-out period in early 2016).

This Sec. 125 cafeteria plan satisfies the preceding rules of this notice.

Example 2.

The same facts as Example 1, except that A’s expenses of $2,700 are incurred and submitted during the month of January 2015 (and not July 2015). The plan may treat $500 of the $800 unused amounts as of December 31, 2014, as available to pay current year expenses. Accordingly, A is reimbursed with respect to the $2,700 claim. The plan treats the first $2,500 of the claim as reimbursed with health FSA contributions for 2015, and the remaining $200 of the claim as reimbursed with the unused amounts as of December 31, 2014. The unused amount remaining from 2014 from which claims for expenses incurred during the 2014 plan year may be reimbursed during the 2014 run-out period in early 2015 is reduced to $600 ($800 – $200).

On February 1, 2015, A submits and is reimbursed with respect to $350 of claims for expenses incurred during the 2014 plan year. After the $350 reimbursement, the unused amount remaining for 2014 from which claims for expenses incurred during the 2014 plan year may be reimbursed during the 2014 run-out period in early 2015 is reduced to $250 ($600 – $350). A submits no further claims for expenses incurred during the 2014 plan year, so that in addition to the $200 previously used to reimburse the January 2015 claim, $250 is carried over to the 2015 plan year. A submits no further claims for 2015. The amount carried over to 2016 is $250.

This Sec. 125 cafeteria plan satisfies the preceding rules of this notice.

Example 3.

The same facts as Example 2, except that on February 1, 2015, A submits claims with respect to $700 of expenses incurred during the 2014 plan year. Because the unused amount remaining from 2014 from which claims for expenses incurred during the 2014 plan year may be reimbursed has been reduced to $600 prior to February 1, 2015, the plan reimburses A for only $600 of the total $700 of claims. After the $600 reimbursement, the unused amount remaining from 2014 from which claims for expenses incurred during the 2014 plan year may be reimbursed is reduced to zero ($600 – $600). A submits no further claims for expenses incurred during the 2014 plan year, so that the amount carried over to the 2015 plan year is $0 (the entire $800 of unused amounts as of December 31, 2014, having been used to reimburse claims submitted in January 2015 ($200) and February 2015 ($600)).

This Sec. 125 cafeteria plan satisfies the preceding rules of this notice.

Example 4.

The same facts as Example 1, except that, for 2014, A elects a salary reduction amount of $600 and, on December 31, 2014, A still has $600 of unused health FSA amounts.

For 2015, A elects no salary reduction for the health FSA, submits no claims during the run-out period, and as of the end of the run-out period on March 31, 2015, $600 in unused health FSA amounts remains. Of that amount, $100 is forfeited because it exceeds the $500 carryover limit, and $500 is carried over to the 2015 plan year. A incurs $200 in expenses during the 2015 plan year, which are reimbursed during that plan year. As of December 31, 2015, A has $300 in unused health FSA amounts.

For 2016, A elects no salary reduction for the health FSA but has the $300 carryover from 2015, which is not forfeited. A incurs medical expenses of $300 in 2016, which are reimbursed using the $300 carryover from 2015.

This Sec. 125 cafeteria plan satisfies the preceding rules of this notice.

Grace Period Rule

A Health FSA plan that incorporates a carryover provision may not also provide for a grace period in the plan year to which unused amounts may be carried over. For example, a calendar year plan permitting a carryover to 2015 of unused 2014 health FSA amounts would not be permitted to have a grace period in 2015, but would be permitted to have had a grace period during the first 2 ½ months of 2014. 

An FSA Grace Period is a plan option that allows expenses for qualified benefits incurred during the grace period to be paid or reimbursed from contributions remaining unused at the end of the immediately preceding plan year. The grace period must not extend beyond the fifteenth day of the third calendar month after the end of the immediately preceding plan year to which it relates. Said another way, a participant who has unused contributions remaining in his/her FSA account from the immediately preceding plan year, and who incurs expenses for a qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused contributions as if the expenses had been incurred in the immediately preceding plan year. The effect of the grace period is that the participant may have as long as 14 months and 15 days (the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are “forfeited” under the “use-it-or-lose-it” rule.  The grace period must apply to all participants in the cafeteria plan.

Example: An Employer with a cafeteria plan year ending on December 31, 2014, has an Employee X who elected a salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2014. As of December 31, 2014, X has $200 remaining unused in his health FSA. X elected a salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2015. During the grace period [for the 2014 plan year] from January 1 through March 15, 2014, X incurs $300 of unreimbursed medical. The unused $200 from the plan year ending December 31, 2014, is applied to pay or reimburse $200 of X’s $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2015, X has no unused benefits or contributions remaining for the plan year ending December 31, 2014. The remaining $100 of medical expenses incurred between January 1 and March 15, 2006, is paid or reimbursed from X’s health FSA for the plan year ending December 31, 2015. As of March 16, 2015, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2015.

Heart Act and FSAs

The Heroes Earnings Assistance and Relief Tax (HEART) Act, enacted June 17, 2008, allows distributions of unused amounts in a Health Flexible Spending Arrangement (FSA) to reservists ordered or called to active duty.  This distribution is referred to as a “qualified reservist distribution” (QRD).  It enables reservists to access unused portions of their Health FSA that they might otherwise lose because of their call to active duty.

The key components of this act are as follows:

• The decision of whether to allow a QRD from a health FSA is optional with the employer.
• A QRD must be reported as wages on the employee’s W-2 form for the year in which the QRD is paid to the employee.
• An employee must request a QRD on or after the date of the order or call to active duty, and before the last day of the plan year (or grace period, if applicable).
• The cafeteria plan must be amended to provide for a QRD from a health FSA.

HEART Distributions

Employers have three options in determining the amount to distribute for the QRD.

• The amount elected for the health FSA for the plan year minus the health FSA reimbursements received as of the date of the request.
• The amount contributed to the health FSA as of the date of the request for distribution minus the health FSA reimbursements received as of the date of the request.
• Some other amount (not exceeding the entire amount elected for the health FSA for the plan year minus reimbursements).

For further guidance, see Notice 2008-82.

IMPORTANT LEGAL NOTICE REGARDING CAFETERIA PLANS:

These types of plans are highly regulated by the Internal Revenue Service, and must be adopted and administered pursuant to detailed federal regulation.  For example, there are regulations governing the circumstances under which participants may be permitted to make mid-year election changes; the types of expenses that may be reimbursed; and complicated rules to make sure that the plan does not discriminate in favor of highly compensated individuals and key employees. Failure to comply with the applicable regulations can lead to disqualification of the plan, and/or significant adverse tax consequences to employers and employees.  Legal counsel should be sought prior to adoption of this type of plan, prior to adoption of any plan changes, and when any issues arise related to plan administration.

Additional Resources

Click Here for Form 5500.

Click Here for the Department of Labor Website (Home Page).

Employers Tax Guide to Fringe Benefits