Module 9
5.1 Discuss how the Employee Retirement Income Security Act (ERISA) affects a cafeteria plan. (Text, p. 174)
A cafeteria plan itself is not governed by 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 that 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, day-care centers, scholarship funds or prepaid legal services are considered welfare benefits. Not all welfare benefit plans can be funded through a cafeteria plan.
1.3 Describe the concept of a cafeteria plan and how it operates in connection with other employee benefit plans sponsored by an employer. (Text, pp. 165-166)
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 (IRC) 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 the participants elected benefits that, if paid for by the employer, could be offered to participants on a tax-free basis.
3.5 Explain what is meant by a full flex plan. (Text, pp. 171-172)
A full flex plan is sometimes called a full choice plan. As both names would suggest, such plans give participants an opportunity to select among 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 purchases. 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
1.2 Describe the tax doctrine of constructive receipt within the context of cafeteria plans. (Text, pp. 164-165 )
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.
4.4 Describe the elements of cafeteria plans that appeal to various demographic cohorts within an employer's workforce. (Text, p. 173)
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 of 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 benefit 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 limits were placed on the cash option. In designing a flex plan, these important issues must be considered, especially in view of the ACA mandated shared responsibility requirements.
2.4 What potential disadvantages do employers face in sponsoring a cafeteria plan? (Text, pp. 168-169)
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 disadvantage 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 tax law via a written plan document. If a health care FSA is 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, while the Affordable Care Act (ACA) relaxed requirements for small employers, 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.
5.4 For a cafeteria plan to be considered qualified with respect to its written form, what provisions must the written plan include? (Text, pp. 180-181)
For a cafeteria plan to be considered qualified with respect to its written form, the written plan must include the following provisions: (a) A specific description of each benefit available under the plan and the period of coverage applicable to each (b) The rules governing employees' eligibility and participation (c) 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 coverage for which elections are effective (d) The manner in which contributions may be made such as via a salary reduction agreement between the employer and employee, nonelective employer contributions or a combination of both (e) 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. (f) The plan year. Also, among the additional documentation requirements under relatively recent proposed regulations are the following provisions: (a) If a cafeteria plan is considered to have welfare benefit plans, a claims provision that satisfies ERISA must be included. (b) If the plan includes a health care reimbursement account, specific language addressing the uniform-coverage rule and use-it-or-lose-it rule must be included. (c) When plan amendments are needed, they must be in writing and may be effective only for periods after the later date of the adoption date or the effective date of the amendment.
2.2 What are the primary disadvantages to an employee in receiving benefits under the umbrella of a cafeteria plan? (Text, p. 167)
From an employee's perspective, the primary disadvantage of a cafeteria plan 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 a health care FSA is the "use-it-or-lose-it" rule subjecting unused benefit dollars at the end of the plan year to forfeiture. (Discussed later, the "use-it-or-lose-it" rule has been liberalized somewhat.) There are other perceived disadvantages to cafeteria plans. An employee—through inertia or lack of knowledge—may be worse off financially by paying for dependent-care expenses through a cafeteria spending account rather than taking the tax credit on his or her personal tax return. 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.
2.3 Discuss the advantages to employers in offering their employee benefits through a cafeteria plan. (Text, pp. 167-168)
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. In addition, 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 these changes on individual employees.
4.5 Why is it important for an employer to develop a carefully crafted communication campaign when establishing a cafeteria plan? (Text, p. 173)
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 plan participation. If employee input is solicited, the plan should be customized to meet the needs of the employees and reflect their suggestions and input as much as possible.
1.4 Explain the tax treatment for employee benefits under IRC Section 125 and the scope of Section 125 (i.e., which benefit plans are included or excluded from preferential tax treatment). (Text, p. 166)
IRC Section 125 significantly changed the tax treatment under prior law, as described previously. 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 (Note: The plan may only benefit employees, not owners, such as partners paid according to a Form K-1 or 2% or greater shareholders of an S corporation) 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 that are permissible for cafeteria plan tax treatment and other benefits that may not be included in a cafeteria plan. Candidate Note: Among benefits that cannot be offered in a cafeteria plan are whole life insurance and long-term care insurance. Oddly, though, a health savings account (HSA) funded through a cafeteria plan may be used to pay premiums for long-term care insurance or for long-term care services. HSA contributions permissible under a cafeteria plan are themselves an exception to the Section 125 special rule that prohibits the deferral of compensation.
3.2 Discuss the characteristics of a premium conversion plan and why it is perceived as a cafeteria plan in its simplest form. (Text, pp. 169-170)
In a premium conversion plan, there are no employer contributions and the plan is offered to employees so 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 its 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 a 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 or she would elect the cash benefit. Accordingly, the employer's contribution to 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 or she is forgoing.
3.2 Discuss the characteristics of a premium conversion plan and why it is perceived as a cafeteria plan in its simplest form. (Text, pp. 169-170)
In a premium conversion plan, there are no employer contributions and the plan is offered to employees so 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 its 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 a 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 or she would elect the cash benefit. Accordingly, the employer's contribution to 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 or she is forgoing. Subsequently, these tax-favored contributions can be spent on additional benefits that are tax-free when paid out to the participant. Cafeteria plans often are referred to using a variety of terms. Some of these terms generically refer to all types of cafeteria plans, while some terms refer to cafeteria plans possessing certain special characteristics. Generic terms would include such references as flexible benefit programs, flexible compensation, choice plans and flex plans. If a plan includes only pretax premium conversion, it often is referred to as a premium conversion plan, premium-only plan or POP. While the different types of cafeteria plans vary in complexity, at their core they are similar in that employees use the plan as a vehicle for obtaining selected employee benefits on a tax-favored basis.
5.2 Cafeteria plans that include welfare plans are subject to what other major laws besides the IRC and ERISA? (Text, pp. 174-175)
In addition to the IRC and ERISA, cafeteria plans that include welfare plans are subject to the following major laws: (a) The Consolidated Omnibus Budget Reconciliation Act of 1985 (COBRA) (b) The Family and Medical Leave Act of 1993 (FMLA) (c) The Health Insurance Portability and Accountability Act of 1996 (HIPAA) (d) The Mental Health Parity Act of 1996 (MHPA) (e) The Newborns' and Mothers' Health Protection Act of 1996 (NMHPA) (f) The Women's Health and Cancer Rights Act of 1998 (WHCRA) (g) The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 (MMA) (h) The Working Families Tax Relief Act of 2004 (WFTRA) (i) Heroes Earnings Assistance and Relief Tax Act of 2008 (HEART) (j) Michelle's Law enacted October 2008 (k) Mental Health Parity and Addiction Equity Act of 2008 (MHPAEA) (l) The Genetic Information Nondiscrimination Act of 2008 (GINA) (m) Patient Protection and Affordable Care Act of 2010 (PPACA).
5.3 What general requirements must a cafeteria plan satisfy in order to be afforded favorable tax treatment? (Text, p. 179)
In order for a cafeteria plan to be afforded favorable tax treatment, the plan must allow participants to choose between two or more benefits consisting of cash (or a taxable benefit that is treated as cash) and qualified benefits. A plan cannot be designed to offer only a choice among qualified benefits, without the cash or cashequivalent component. Without the cash component, the plan is not a cafeteria plan. A salary reduction agreement is sufficient to satisfy the cash requirement. If a participant wanted to elect cash in a salary-reduction-only cafeteria plan, he or she would elect not to reduce his or her salary, thus receiving his or her total compensation in cash.
4.2 Why do employers develop credit values for use in flexible benefit plans rather than use the actual dollar values associated with premium costs? (Text, p. 172)
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.
4.3 What is a core benefit within a flexible benefit plan, and what purpose does the core benefit serve? (Text, p. 172)
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 an employee to cash out of a core benefit if proof of alternate coverage is supplied. 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. Candidate Note: Under the Affordable Care Act (ACA), large employers (those that employed at least 50 "full-time equivalent" employees in the prior year) must offer "minimum value" and "affordable" health coverage to full-time employees and their children under the age of 26. The affordability test applies to the lowest cost option that also meets ACA minimum value requirements. Non-tax-deductible penalties are imposed if employers fail to comply.
1.1 What are the two primary factors that contribute to the popularity of cafeteria plans? (Text, pp. 164-165)
The two primary factors that contribute to the popularity of cafeteria plans (often called flexible benefit plans or flex plans) are: (1) The ever-increasing costs of benefits (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. With employee benefits representing a large component of labor costs for most organizations, it is important to spend employee benefit dollars in a costefficient way that maximizes value. A cafeteria plan assures that the employer maximizes the value of its benefit dollars and avoids spending money on duplicated or unneeded benefits. 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 share costs with the employer, the tax advantages and choice in benefits selection become particularly appealing.
4.1 Discuss the methodology utilized to value credits used by plan participants to purchase benefits under a flexible benefit plan. (Text, p. 172)
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. Among these factors are: (a) The number of credits a participant will be given (b) The acceptable level of employee contribution (c) The number of participants expected to select each benefit offered (d) The number of credits that are expected to be paid as a cash benefit (e) The purchase price of benefit options (f) The hidden employer subsidies (g) The total premium cost.
2.1 What are the primary advantages to an employee in receiving benefits under a cafeteria plan? (Text, pp. 166-167)
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 the Federal Insurance Contributions Act (FICA-Social Security) and the Federal Unemployment Tax Act (FUTA) taxes. Also, most state and local tax laws follow the federal tax treatment.
3.1 Given that cafeteria plans are not all the same, describe the different types of cafeteria plans allowable under IRC Section 125. (Text, p. 169)
Undoubtedly, cafeteria plans are not all the same, and there are several different types of cafeteria plans that are allowable under Section 125 of the IRC. Although these different plans vary in terms of actual plan features, they are equally considered to be cafeteria plans under the law. Cafeteria plans were given their name because benefits are offered to employees cafeteria-style, with plan participants selecting the benefits they need. These optional benefits are purchased with dollars or credits given to the participant as part of a benefit package. In some instances, employees are not given any employer money to spend but can enhance their overall benefit package by making tax-favored contributions to the cafeteria plan. Subsequently, these tax-favored contributions can be spent on additional benefits that are tax-free when paid out to the participant. Cafeteria plans often are referred to using a variety of terms. Some of these terms generically refer to all types of cafeteria plans, while some terms refer to cafeteria plans possessing certain special characteristics. Generic terms would include such references as flexible benefit programs, flexible compensation, choice plans and flex plans. If a plan includes only pretax premium conversion, it often is referred to as a premium conversion plan, premium-only plan or POP. While the different types of cafeteria plans vary in complexity, at their core they are similar in that employees use the plan as a vehicle for obtaining selected employee benefits on a tax-favored basis.
