GBA 2 - Assignment #5 - Flexible Benefits I
Popularity of Cafeteria Plans
1. The increasing costs of benefits, and 2. A diverse workforce with vastly differing employee benefit needs Permitting employees to select those benefits that are most applicable to their personal financial circumstances makes sense for both the employee and the employer. Since employee benefits have become more costly to organizations, it is important to spend employee benefit dollars in a cost-effective way that maximizes value. A cafeteria plan assures that the employer maximizes the value of its dollars and avoids spending money on duplicated or unneeded benefits. Cafeteria plans are available to a significant number of U.S. workers with billions spent annually through flexible soending accounts. These FSAs may be funded both by employer contributions and employee pretax contributions, although often they are funded just with e oloyee oretax contributions. Before the advent of flex plans, optional or supplemental benefits were paid by the employee using after-tax dollars. A flexible benefit plan allows employees to contribute toward benefits on a tax-favored basis. As certain benefit programs have become more costly, notably health care, and more employees are asked to cost-share with the employer, the tax advantages and choice in benefits selection become particularly appealing.
ERISA Applicability to Benefit Programs in a Flex Plan
A cafeteria plan itself is not governed by the Employee Retirement Income Security Act (ERISA) because it is not classified as a welfare benefit plan under ERISA Section 3. However, some of the underlying benefits that are funded through a cafeteria plan may be subject to ERISA because they are considered to be welfare benefit plans. ERISA Section 3 defines a welfare benefit plan as any plan, fund or program which is established or maintained by an employer or employee organization for the purposes of providing participants' or beneficiaries' medical, surgical or hospital care or benefits in the event of sickness , accident, disability, death or unemployment. In addition, benefits for vacation, apprenticeship programs or other training programs, daycare centers, scholarship funds or prepaid legal services are considered welfare benefits. Not all welfare benefit plans can be funded through a cafeteria plan.
IRC Section 125
A cafeteria plan operates in connection with other employee benefit plans sponsored by an employer. In fact, an essential concept in understanding a cafeteria plan is recognition that the cafeteria plan really is an umbrella plan under which tax-favored employee benefits are offered. The cafeteria plan is merely a mechanism to pay for employee benefits. Internal Revenue Code Section 125 and the regulations related thereto govern cafeteria plan arrangements while other IRC sections apply to the underlying benefits funded within the cafeteria plan. Section 125 was added to the IRC by the Revenue Act of 1978. Prior to the enactment of this section of the IRC, the tax treatment of benefits involving participant choice was quite different. If a participant had any type of choice with respect to available benefits, the tax doctrine of constructive receipt required that the participant be taxed as if he or she had elected the maximum available taxable benefits. The rationale was that since participants could elect these amounts in cash, they should be taxed as if they had elected the cash. This was the case even if participants elected benefits that, if paid for by the employer, could be offered to participants on a tax-free basis. IRC Section 125 provided favorable tax treatment to certain benefits funded through a cafeteria plan. It specifically defined a cafeteria plan to mean a plan under which all participants are employees and under which all participants may choose among two or more benefits consisting of a combination of qualified benefits and cash. If the requirements of IRC Section 125 are met and the benefits are eligible for inclusion in a cafeteria plan, then the benefits are not considered as taxable income to the participant if benefit coverage is chosen. On the other hand, if cash is selected and paid to participants, the cash payment would be fully taxable as compensation. It is important to note that Section 125 has a clearly defined scope with some benefits permissible for cafeteria plan tax treatment, while other benefits may not be included in a cafeteria plan.
Full Flex Plan
A full flex plan is sometimes called a full choice plans. As both names would suggest, such plans give participants an opportunity to select a on a full range of benefits. Under such a plan, the employer determines a dollar value it wishes to earmark for the benefits portion of total compensation. This dollar value is in addition to any salary reductions employees choose to direct to reimbursement accounts or additional benefit purchase. Once an employer has computed the dollar value it wishes to contribute to benefits, either the cash is contributed to the cafeteria plan or a credit system is developed whereby credit amounts are used to fund the similarly credit-priced benefit options.
Benefits Typically Using a Premium Conversion Feature
Although there can be variation, as a general rule, premium conversion feature is only used for medical insurance (including dental, vision, and other types of medical coverage) and group term life insurance not in excess of $50,000. In some instances, the plan may provide that outside employee- owned policies can be paid for through the premium conversion feature provided that the insurance is not from another employers-sponsored plan. The August 2007 regulations specifically permit employers to use a cafeteria plan to allow employees to lay for their own individual policies on a pretax basis. A cafeteria plan may also allow an employee to pay COBRA premiums on a pretax basis. A cafeteria plan may also allow an employee to pay COBRA premiums for a child who has reached the limiting age under the plan. The regulations now allow an employee to pay COBRA premiums on a pretax basis for a prior employer's coverage through the new employer's cafeteria plan. Note that health FSAs may not reimburse individual or COBRA premiums. Disability policies can be paid by premium conversion under the law, but frequently are purchased using after-tax dollars instead of pretax dollars. This occurs because if the premiums are tax-free, any disability payment subsequently made will be considered taxable when paid. Considering the relatively low cost of disability coverage, most employees prefer to have their disability payments, if any are made, paid on a tax-free basis.
Constructive Receipt
Cafeteria plans operate as an exception to the tax doctrine of constructive receipt. Usually, when an individual has control over how money is spent, it becomes taxable to that individual. However, provided a cafeteria plan is designed in accordance with all applicable tax laws, a cafeteria plan participant can avoid taxation and instead receive tax-free benefits.
Cafeteria Plans That Appeal to Various Demographic Cohorts
Certain elements of a cafeteria plan may have particular appeal to certain demographic cohorts. Some of these features, in essence, are more highly valued by one group employees than they are by another group of employees. It is essential for the employer to understand what features of the plan may appeal to specific segments of the workforce. Higher paid employees typically value opportunities to reduce personal taxes through flexible benefits plans. Dollar maximums limiting contributions to reimbursement accounts would likely concern higher paid employees. Generally, lower paid employees are not very interested in tax savings; rather, they prefer to maximize their weekly take-home pay. If an employer's demographics consist largely of lower paid workers, a full flex plan offering a generous cash option could result in employees not being adequately protected unless adequate core benefits were mandated or limited were placed on the cash option. In designing a flex plan, these important issues must be considered.
Disadvantages of Cafeteria Plan Sponsorship
Even though there are many advantages from an employer's perspective in sponsoring a cafeteria plan, there also are potential disadvantages for the employer. The primary disadvantages to the employer involves the ongoing cost of administration and operation of such a plan. Although these costs can be offset to a significant extent by payroll tax savings, the employer must be cognizant that establishing and operating a cafeteria plan involves additional administrative complexity and costs. Some of this additional complexity involves compliance with tax law provisions. A flexible benefit plan is required to be operated in accordance with strict adherence to federal law via a written plan document. If a health care FSA so offered as a component of the plan, the uniform coverage rules mandate that the full amount of the benefit elected be available during the entire plan year regardless of how much an employee has actually contributed to date. Essentially an employer incurs cash flow risk if claims exceed employee plan contributions early in the plan year. Employers may also incur financial risk if terminating employees' claims exceed contributions and recoveries of these funds cannot occur. Adverse selection becomes a greater risk when employees can opt in and out of various benefit plans. If all the less healthy participants select the most comprehensive insurance coverage and the more healthy participants select minimum or no health coverage, the overall plan costs may increase. This occurs since utilization increases in the more comprehensive plan with fewer more favorable risks present. Finally, cafeteria plans are subject to complex coverage and nondiscrimination testing in order to comply with federal tax law. Some of these tests apply to the flexible benefit plan as a whole, while others apply to the underlying benefits. Depending upon the demographics of the workforce, some of these tests may be difficult to pass, in which case the favorable tax treatment could be restricted with respect to the owners and other highly paid employees.
Required Written Provisions for a Cafeteria Plan Document
For a cafeteria plan to be qualified with respect to it's written from the written plan must include the following provisions: 1. A specific description of each benefit available under the plan and the period of coverage applicable to each. 2. The rules governing employees' eligibility and participation. 3. The procedures for making participant elections under the plan, including when elections may be made, rules governing the irrevocability of elections and the period of core age for which elections are effective. 4. The manner in which contributions may be made such as via a salary reduction agreement between the employer and employee, non elective employer contributions or a combination of both. 5. The maximum amount of employer contributions available to any participant. To meet this requirement, the plan must describe the maximum amount of elective contributions available to any participant either by stating the maximum dollar amount or maximum percentage of compensation that may be contributed as elective contributions or by stating the method for determining the maximum amount or percentage of elective contributions that a participant may make. 6. The plan year. Also among the additional documentation requirements under relatively recent proposed regulations are the following provisions: 1. If a cafeteria plan is considered to have welfare benefit plans, a claims provision that satisfies ERISA must be included. 2. If a plan includes a health care reimbursement account, specific language addressing the uniform-coverage rule and use-or-lose-it rule must be included. 3. When plan amendments are needed, they must be in writing and may be only effective for periods after the later date of the adoption date or the effective date of the amendment.
Disadvantages of Cafeteria Plan Participation
From an employee's perspective, the primary disadvantage is the fact that benefit elections generally must be made prior to the beginning of the plan year and, with limited exception, the election is irrevocable during the entire period of coverage. Another significant disadvantage that applies to FSAs is the "use it or lose it" rule. Under this rule, any benefit dollars that are present in the FSA at the end of the plan year and are unused are subject to forfeiture. There are other perceived disadvantages to cafeteria plans. An employee may be better off financially by taking the tax credit on his or her personal tax return rather than paying for dependent care expenses through a cafeteria plan spending account. Also, since there is no FICA-Social Security tax on cafeteria plan benefit dollars, an employee who participates in a cafeteria plan may realize a slight reduction in Social Security benefits or in the accumulation of benefits under his or her employer-sponsored retirement plan.
Advantages of Cafeteria Plan Sponsorship
From an employer's perspective, there are several advantages to offering employee benefits through a cafeteria plan. First, there are significant financial incentives. The employer realizes payroll cost savings because the employer does not pay FICA or FUTA taxes on amounts contributed to the cafeteria plan. Additionally, deferral amounts are not considered wages for purposes of determining workers' compensation premiums and other payroll-based expenses. State and local tax treatment varies, with many states offering the same preferential tax treatment as offered by the federal government. In addition to financial incentives, cafeteria plans create greater employee awareness of the overall value of their benefits. The flexible benefit structure can also serve as a mechanism to control escalating benefit costs, limiting employer contributions and preventing the wasting of benefit dollars on duplicate or unneeded benefits. This is particularly true in the realm of health care costs. To the extent that an employer is considering implementing benefit changes that will result in employees sharing more of the cost or employer caps on benefit plan contributions, a flexible benefit plan is an excellent tool to minimize the financial impact of here changes on individual employees.
Communication Campaigns for Flexible Benefits Programs
Generally an employer must be prepared for negative reactions and criticism from employees when establishing a cafeteria plan. Without proper communication including adequate time for questions and answers, the employees could view the cafeteria plan as a way for their employer to pay them less. The carefully crafted communication program should include both the positives and negatives of a plan participation. If employee input is solicited, the plan should be custom crafted to meet the needs of the employees and reflect their suggestions and input as much as is possible.
Premium Conversion Plans
In a premium conversion plan there are no employer contributions and the plan is offered to employees so that they may pay for their insurance costs on a tax-favored basis. Because there are no employer contributions or flexible credits, this type of plan is perceived as a cafeteria plan in it's simplest form. A cafeteria plan is the only means that can be used for employees to pay for insurance costs on a tax-favored basis. Absent written cafeteria plan, the tax-free treatment of premium payments will be disallowed. If the employer is going to allow employees to opt out of employer-paid insurance coverage, this must occur through a cash option within a cafeteria plan. For the employee who does not desire the insurance coverage, he/she would elect the cash benefit. Accordingly, the employer's contribution o the plan would be paid to the employee as cash compensation (at which point any favorable tax treatment is lost). An employer need not offer a dollar-for-dollar cash option. In other words, the amount credited to an employee for opting out of coverage can be less than the actual cost of the coverage he/she is foregoing.
Credit Values Opposes to Actual Dollar Values
Oftentimes employers develop credit values rather than use the actual dollar values associated with premium costs because such a system can smooth out benefit inequities. This makes it possible for the employer to offer a cash option that is not a dollar-for-dollar value. Accordingly, such pricing makes the benefits more valuable than cash. Sometimes it is thought that providing the full cash value of the benefits will be too appealing to participants and result in employees being underinsured.
Cafeteria Plans Involving FSAs
One type of cafeteria plan includes FSAs, also called reimbursement accounts. Most often these are bookkeeping accounts with the actual funds remaining as part of the employer's general assets. Records are maintained showing the activity in each participant's individual account. When an FSA is funded purely by salary deferrals, the participant is choosing between two or more benefits consisting of cash and qualified benefits. FSAs offer an employee the ability to fund certain qualified benefits on a pretax basis through a salary reduction agreement or a combination of salary reductions and employer contributions. FSAs are permitted for medical reimbursements, dependent-care assistance and adoption assistance. Both medical and dependent care reimbursement accounts most often only involve employee contributions on a pretax basis. Throughout the plan year, as expenses are incurred for the participant and his/her dependents, he or she submits claims to the plan for reimbursement. The coverage period for an FSA normally is 12 months. A cafeteria plan may include a grace period of up to 2 1/2 months after the end of the plan year, during which employees with unused contributions for a particular benefit may be reimbursed for expenses incurred during the grace period. Grace periods may apply to health care and dependent care FSAs and adoption assistance plans, but not elective paid time off. Also, funds from one account may not be used to reimburse expenses in another account. Employers may also limit the amount carried over during the grace period, as long as the limit is applied uniformly and is not based on a percentage of unused contributions remaining at the end of the plan year.
Core Benefit Within Flex Plan
The idea of a core benefit is to establish some minimum level of benefit coverage below which the company will not permit an employee to go. Sometimes a company will allow a employee to cash out of a core benefit if proof of alternate coverage is supplies. For instance, an individual may possess coverage through a spouse's plan or someone who qualified for early retirement through a previous employer may be exempted because of retiree coverage through the previous employer. Typically a core benefit may require that the participant select some basic health coverage and a minimum level of life insurance. The core benefit is intended to supply a basic level of protection so that employees cannot be underinsured. In protecting the employee from extreme deprivation, the plan sponsor is also protecting its own interest as well. This is the case, since employees experiencing adverse circumstances may seek assistance for the company claiming they were poorly served by the flex plan. Such claims can, at the very least, result in unfavorable and embarrassing publicity and, at the other extreme, may result in legal claims alleging lapses of fiduciary oversight or failure to make adequate plan disclosures.
Valuation of Flex Plan Credits
The typical methodology utilized to value credits used by plan participants to purchase benefits under a flex plan involves understanding the appropriate pricing parameters of the benefits and developing a pricing matrix. The pricing matrix takes into account several factors. 1. The number of credits a participant will be given 2. The acceptable level of employee contributions 3. The number of participants expected to select each benefit offered 4. The number of credits that are expected to be paid as a cash benefit 5. The purchase price of benefit options 6. The hidden employer subsidies 7. The total premium cost
Advantages of Cafeteria Plan Participation
There are a number of advantages when an employee receives benefits under a cafeteria plan. However, the most notable advantage is probably the preferential tax treatment afforded to these benefits. Employees directly save money since they pay for their share of benefit expenses on a tax-favored basis. Contributions to a cafeteria plan are exempt from federal income tax and are not subject to FICA and FUTA taxes. Also, most star and local tax laws follow the federal tax treatment.
