From the Hotline: Cafeteria Plan and Ending Section 125 Status

Question: What is the appropriate way to end status as a section 125 employer so that employees may elect post-tax deductions?

Answer: A cafeteria plan, set forth in writing and administered in accordance with Internal Revenue Code § 125, is required in order for employees to elect pretax deductions for group health coverage or other qualified benefits. In the absence of a cafeteria plan, any coverage costs deducted from the employee’s pay would first be subject to income taxes and employment taxes.

Generally, cafeteria plan amendments must be adopted before the start of the plan year (or coverage period) to which the change applies. The IRS cafeteria plan regulations require each plan year to be 12 months. The plan may be amended or terminated for a “short” plan year (fewer than 12 months), but only for a valid business reason.

Further, the regulations provide examples of two situations that would be considered valid business reasons for a short plan year. In one case, the first plan year is short in order to start the second plan year on a calendar-year basis. In the second example, the cafeteria plan year is amended due to a change in health insurance carrier. For reference, the following is an excerpt of pertinent text from Treas. Prop. Reg. 1.125-4 (published in Federal Register 8/6/2007):

(d) Plan year requirements—

(1) Twelve consecutive months. The plan year must be specified in the cafeteria plan. The plan year of a cafeteria plan must be twelve consecutive months, unless a short plan year is allowed under this paragraph (d). A plan year is permitted to begin on any day of any calendar month and must end on the preceding day in the immediately following year (for example, a plan year that begins on October 15, 2007, must end on October 14, 2008). A calendar year plan year is a period of twelve consecutive months beginning on January 1 and ending on December 31 of the same calendar year. A plan year specified in the cafeteria plan is effective for the first plan year of a cafeteria plan and for all subsequent plan years, unless changed as provided in paragraph (d)(2) of this section.

(2) Changing plan year. The plan year is permitted to be changed only for a valid business purpose. A change in the plan year is not permitted if a principal purpose of the change in plan year is to circumvent the rules of section 125 or these regulations. If a change in plan year does not satisfy this subparagraph, the attempt to change the plan year is ineffective and the plan year of the cafeteria plan remains the same.

(3) Short plan year. A short plan year of less than twelve consecutive months is permitted for a valid business purpose.

(4) Examples. The following examples illustrate the rules in paragraph (d) of this section:

Example 1. Employer with calendar year. Employer G, with a calendar taxable year, first establishes a cafeteria plan effective July 1, 2009. The cafeteria plan specifies a calendar plan year. The first cafeteria plan year is the period beginning on July 1, 2009, and ending on December 31, 2009. Employer G has a business purpose for a short first cafeteria plan year.

Example 2. Employer changes insurance carrier. Employer H establishes a cafeteria plan effective January 1, 2009, with a calendar year plan year. The cafeteria plan offers an accident and health plan through Insurer X. In March 2010, Employer H contracts to provide accident and health insurance through another insurance company, Y. Y’s accident and health insurance is offered on a July 1–June 30 benefit year. Effective July 1, 2010, Employer H amends the plan to change to a July 1–June 30 plan year. Employer H has a business purpose for changing the cafeteria plan year and for the short plan year ending June 30, 2010.

In summary, a cafeteria plan generally should not be amended or terminated during a plan year for which employees have already made benefit elections. The employer is advised to consult legal counsel for additional guidance.

In the event the cafeteria plan becomes disqualified, the employees’ pretax contributions would become taxable compensation. Taxable compensation is subject to income taxes (paid by employees) and employment taxes (paid by employers and employees).