On August 3, 2007, the Internal Revenue Service issued new proposed regulations for the administration of Code Section 125 Cafeteria Plans.  The new regulations preserve the rules of existing Cafeteria Plans, but clarify statutory and administrative changes that have been made since the previous regulations were published.

What are Cafeteria Plans?

Cafeteria Plans allow employees to make a choice between receiving taxable cash compensation or tax-free employee benefits — for example, health care, dependent care, and other fringe benefits — without having to pay taxes on the otherwise non-taxable benefits. 

How will Cafeteria Plans be changed by the proposed regulations?

The new proposed regulations generally preserve the rules of the existing proposed regulations, but clarify statutory and administrative changes that have been made since the previous regulations were published.  The new regulations also address many issues on which the IRS has provided informal guidance.

Highlights of the new proposed regulations:

• The new regulations will clarify that cafeteria plans are in most instances the sole method of preserving the non-taxable nature of employer-provided benefits where employees are allowed to elect between taxable compensation and non-taxable benefits;
• The regulations have new rules for determining if a cafeteria plan improperly discriminates in favor of highly compensated employees, including definitions of key terms.  For the most part, these rules are consistent with the rules for qualified retirement plans.  The rules also provide an objective test to determine if the actual election of benefits is discriminatory;
• The regulations incorporate guidance previously issued relating to debit cards and grace periods for using health flexible spending arrangement (Health FSA) money after the end of a plan year;
• The regulations retain most rules for Health FSAs, including a 12-month plan year, the requirement that the full reimbursement amount be available at any time during the plan year, restrictions on changing elections in mid-plan year, and the requirement that unused amounts at plan year end must be forfeited (the “use-it or lose-it” rule).

When will the new regulations be effective?

A copy of the new regulations can be viewed at the IRS website. Any interested party may submit written or electronic comments to the IRS until November 5, 2007.  The IRS will hold hearings on November 15, 2007.  Taxpayers may rely on the new proposed regulations pending the issuance of final regulations.