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Monday,

August 6, 2007

Part III

Department of the
Treasury
Internal Revenue Service

26 CFR Part 1
Employee Benefits—Cafeteria Plans;
Proposed Rule
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43938 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

DEPARTMENT OF THE TREASURY Paperwork Reduction Act number assigned by the Office of
The collections of information Management and Budget.
Internal Revenue Service Books or records relating to a
contained in this notice of proposed
collection of information must be
rulemaking have been submitted to the
26 CFR Part 1 retained as long as their contents may
Office of Management and Budget for
become material in the administration
review in accordance with the
[REG–142695–05] of any internal revenue law. Generally,
Paperwork Reduction Act of 1995 (44
tax returns and tax return information
U.S.C. 3507(d)). Comments on the
are confidential, as required by 26
RIN 1545–BF00 collections of information should be
U.S.C. 6103.
sent to the Office of Management and
Employee Benefits—Cafeteria Plans Budget, Attn: Desk Officer for the Background
Department of Treasury, Office of This document contains proposed
AGENCY: Internal Revenue Service (IRS),
Information and Regulatory Affairs, Income Tax Regulations (26 CFR Part 1)
Treasury.
Washington, DC 20503, with copies to under section 125 of the Internal
ACTION: Withdrawal of prior notices of the Internal Revenue Service, Attn: IRS Revenue Code (Code). On May 7, 1984,
proposed rulemaking, notice of Reports Clearance Officer, December 31, 1984, March 7, 1989,
proposed rulemaking and notice of SE:W:CAR:MP:T:T:SP, Washington, DC November 7, 1997, and March 23, 2000,
public hearing. 20224. Comments on the collections of the IRS and Treasury Department
information should be received by published proposed amendments to 26
SUMMARY: This document contains new October 5, 2007. Comments are CFR Part 1 under section 125 in the
proposed regulations providing specifically requested concerning: Federal Register (49 FR 19321, 49 FR
guidance on cafeteria plans. This Whether the proposed collections of 50733, 54 FR 9460, 62 FR 60196 and 65
document also withdraws the notices of information are necessary for the proper FR 15587). These 1984, 1989, 1997 and
proposed rulemaking relating to performance of the functions of the 2000 proposed regulations are hereby
cafeteria plans under section 125 that Internal Revenue Service, including withdrawn. Also, the temporary
were published on May 7, 1984, whether the information will have regulations under section 125 that were
December 31, 1984, March 7, 1989, practical utility; published on February 4, 1986 in the
November 7, 1997 and March 23, 2000. The accuracy of the estimated burden Federal Register (51 FR 4318) are being
In general, these proposed regulations associated with the proposed collection withdrawn in a separate document. The
would affect employers that sponsor a of information; new proposed regulations that are
cafeteria plan, employees that How the quality, utility, and clarity of published in this document replace
participate in a cafeteria plan, and third- the information to be collected may be those proposed regulations.
party cafeteria plan administrators. enhanced;
DATES: Written or electronic comments How the burden of complying with Explanation of Provisions
must be received by November 5, 2007. the proposed collections of information Overview
Outlines of topics to be discussed at the may be minimized, including through The new proposed regulations are
hearing scheduled for November 15, the application of automatic collection organized as follows: general rules on
2007, at 10 a.m., must be received by techniques or other forms of information qualified and nonqualified benefits in
October 25, 2007. technology; and cafeteria plans (new proposed § 1.125–
ADDRESSES: Send submissions to: Estimates of the capital or start-up 1), general rules on elections (new
CC:PA:LPD:PR (REG–142695–05), room costs and costs of operation, proposed § 1.125–2), general rules on
5203, Internal Revenue Service, P.O. maintenance, and purchase of service to flexible spending arrangements (new
Box 7604, Ben Franklin Station, provide information. proposed § 1.125–5), general rules on
Washington, DC 20044. Submissions The collection of information in this substantiation of expenses for qualified
may be hand delivered Monday through proposed regulation is in § 1.125–2 benefits (new proposed § 1.125–6) and
Friday between the hours of 8 a.m. and (cafeteria plan elections); § 1.125–6(b)– nondiscrimination rules (new proposed
4 p.m. to CC:PA:LPD:PR (REG–142695– (g) (substantiation of expenses), and § 1.125–7). The new proposed
05), Courier’s Desk, Internal Revenue § 1.125–7 (cafeteria plan regulations, new Proposed §§ 1.125–1,
Service, 1111 Constitution Avenue, nondiscrimination rules). This 1.125–2, 1.125–5, 1.125–6 and § 1.125–
NW., Washington, DC or sent information is required to file 7, consolidate and restate Proposed
electronically via the Federal employment tax returns and Forms W– § 1.125–1 (1984, 1997, 2000), § 1.125–2
eRulemaking Portal at http:// 2. The collection of information is (1989, 1997, 2000) and § 1.125–2T
www.regulations.gov (IRS REG–142695– voluntary to obtain a benefit. The likely (1986). Unless otherwise indicated,
05). The public hearing will be held at respondents are Federal, state or local references to ‘‘new proposed
the IRS Auditorium, Internal Revenue governments, business or other for- regulations’’ or ‘‘these proposed
Building, 1111 Constitution Avenue, profit institutions, nonprofit regulations’’ mean the proposed section
NW., Washington, DC. institutions, and small businesses or 125 regulations being published in this
organizations. document.
FOR FURTHER INFORMATION CONTACT: Estimated total annual reporting The new proposed regulations reflect
Concerning the proposed regulations, burden: 34,000,000 hours. changes in tax law since the prior
Mireille T. Khoury at (202) 622–6080; Estimated average annual burden per regulations were proposed, including:
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concerning submissions of comments, respondent: 5 hours. the change in the definition of


the hearing, and/or to be placed on the Estimated annual frequency of dependent (section 152) and the
building access list to attend the responses: once. addition of the following as qualified
hearing, Oluwafunmilayo Taylor of the An agency may not conduct or benefits: adoption assistance (section
Publications and Regulations Branch at sponsor, and a person is not required to 137), additional deferred compensation
(202) 622–7180 (not toll-free numbers). respond to, a collection of information benefits described in section
SUPPLEMENTARY INFORMATION unless it displays a valid control 125(d)(1)(B), (C) and (D), Health Savings

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43939

Accounts (HSAs) (sections 223, gross income by the employees. When satisfy the section 125 requirements
125(d)(2)(D) and 4980G), and qualified employees may elect between taxable include: Offering nonqualified benefits;
HSA distributions from health FSAs and nontaxable benefits, this election not offering an election between at least
(section 106(e)). Other changes include results in gross income to employees, one permitted taxable benefit and at
the prohibition against long-term care unless a specific Internal Revenue Code least one qualified benefit; deferring
insurance and long-term care services (Code) section (such as section 125) compensation; failing to comply with
(section 125(f)) and the addition of the intervenes to prevent gross income the uniform coverage rule or use-or-lose
key employee concentration test in inclusion. Thus, except for an election rule; allowing employees to revoke
section 125(b)(2). made through a cafeteria plan that elections or make new elections during
The prior proposed regulations, satisfies section 125 or another specific a plan year, except as provided in
§§ 1.125–1 and 1.125–2, provide the Code section (such as section 132(f)(4)), § 1.125–4; failing to comply with
basic framework and requirements for any opportunity to elect among taxable substantiation requirements; paying or
cafeteria plans and elections under and nontaxable benefits results in reimbursing expenses incurred for
cafeteria plans. The prior proposed inclusion of the taxable benefit qualified benefits before the effective
regulations also outlined the most regardless of what benefit is elected and date of the cafeteria plan or before a
significant rules for benefits under a when the election is made. This period of coverage; allocating
health flexible spending arrangement interpretation of section 125 is experience gains (forfeitures) other than
(health FSA) offered by a cafeteria consistent with the legislative history of as expressly allowed in the new
plan—the requirement that the section 125. The legislative history proposed regulations; and failing to
maximum reimbursement be available begins with the interim ERISA rules for comply with grace period rules.
at all times during the coverage period cafeteria plans:
(the uniform coverage rule), the Definition of a Cafeteria Plan
Under * * * ERISA, an employer The new proposed regulations
requirement of a 12-month period of
contribution made before January 1, 1977, to
coverage, the requirement that the provide that a cafeteria plan is a
a cafeteria plan in existence on June 27, 1974,
health FSA only reimburse medical is required to be included in an employees’
separate written plan that complies with
expenses, the requirement that all gross income only to the extent that the the requirements of section 125 and the
medical expenses be substantiated by a employee actually elects taxable benefits. In regulations, that is maintained by an
third party before reimbursement, the the case of a plan not in existence on June employer for employees and that is
requirement that expenses be incurred 27, 1974, the employer contribution is operated in compliance with the
during the period of coverage, and the required to be included in an employee’s requirements of section 125 and the
prohibition against deferral of gross income to the extent the employee regulations. Participants in a cafeteria
compensation (including the use-or-lose could have elected taxable benefits. S. Rep. plan must be permitted to choose among
No. 1263, 95th Cong., 2d Sess. 74 (1978), at least one permitted taxable benefit
rule). The prior proposed regulations
reprinted in 1978 U.S.C.C.A.N. 6837; H. R.
also provided guidelines for dependent (for example, cash, including salary
Rep. No. 1445, 95th Cong., 2d Sess. 63
care FSAs, and the application of (1978); H.R. Conf. Rep. No. 1800, 95th Cong.,
reduction) and at least one qualified
section 125 to paid vacation days 2d Sess. 206 (1978). benefit. A plan offering only elections
offered under a cafeteria plan. These among nontaxable benefits is not a
remain substantially unchanged in the The legislative history also provides: cafeteria plan. Also, a plan offering only
new proposed regulations, with certain [G]enerally, employer contributions under elections among taxable benefits is not
clarifications. Finally, the prior a written cafeteria plan which permits a cafeteria plan. See Rev. Rul. 2002–27,
proposed regulations included a number employees to elect between taxable and Situation 2 (2002–1 CB 925), see
of Q & As addressing transitional issues nontaxable benefits are excluded from the § 601.601(d)(2)(ii)(b). Finally, a cafeteria
gross income of an employee to the extent plan must not provide for deferral of
relating to the enactment of section 125, that nontaxable benefits are elected. S. Rep.
as well as the application of the now- compensation, except as specifically
No. 1263, 95th Cong., 2d Sess. 75 (1978),
repealed section 89 (special reprinted in 1978 U.S.C.C.A.N. 6838; H. R. permitted in section 125(d)(2)(B), (C), or
nondiscrimination rules with respect to Rep. No. 1445, 95th Cong., 2d Sess. 63 (D).
certain employee benefit plans). These (1978). See also H.R. Conf. Rep. No. 1800, Written Plan
provisions are omitted from the new 95th Cong., 2d Sess. 206 (1978).
proposed regulations. Section 125(d)(1) requires that a
The legislative history to the 1984 cafeteria plan be in writing. The
I. New Proposed § 1.125–1—Qualified amendments to section 125 continues: cafeteria plan must be operated in
and Nonqualified Benefits in Cafeteria The cafeteria plan rules of the Code accordance with the written plan terms.
Plans Section 125 Exclusive provide that a participant in a The new proposed regulations require
Noninclusion Rule nondiscriminatory cafeteria plan will not be that the written plan specifically
Section 125 provides that, except in treated as having received a taxable benefit describe all benefits, set forth the rules
offered under the plan solely because the
the case of certain discriminatory participant has the opportunity, before the
for eligibility to participate and the
benefits, no amount shall be included in benefit becomes available, to choose among procedure for making elections, provide
the gross income of a participant in a the taxable and nontaxable benefits under the that all elections are irrevocable (except
cafeteria plan (as defined in section plan. to the extent that the plan includes the
125(d)) solely because, under the plan, H.R. Conf. Rep. No. 861, 98th Cong., 2d optional change in status rules in
the participant may choose among the Sess. 1173 (1984), reprinted in 1984 § 1.125–4), and state how employer
benefits of the plan. The new proposed U.S.C.C.A.N. 1861. See also H.R. Conf. Rep. contributions may be made under the
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regulations clarify and amplify the No. 736, 104th Cong., 2d Sess. 295, reprinted plan (for example, salary reduction or
general rule in the prior proposed in 1996 U.S.C.C.A.N. 2108. nonelective employer contributions),
regulations that section 125 is the The new proposed regulations the maximum amount of elective
exclusive means by which an employer provide that unless a plan satisfies the contributions, and the plan year. If the
can offer employees a choice between requirements of section 125 and the plan includes a flexible spending
taxable and nontaxable benefits without regulations, the plan is not a cafeteria arrangement (FSA), the written plan
the choice itself resulting in inclusion in plan. Reasons that a plan would fail to must include provisions complying

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43940 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

with the uniform coverage rule and the compensation (including salary cafeteria plan and outside a cafeteria
use-or-lose rule. Because section reduction), payment for annual leave, plan), the cost of coverage exceeding
125(d)(1)(A) states that a cafeteria plan sick leave, or other paid time off, coverage of $50,000 is includible in the
is a written plan under which ‘‘all severance pay, property, and certain employee’s gross income. For this
participants are employees,’’ the new after-tax employee contributions. purpose, the cost of group-term life
proposed regulations require that the Distributions from qualified retirement insurance is shown in § 1.79–3(d)(2),
written cafeteria plan specify that only plans are not cash or taxable benefits for Table I (Table I). The Table I cost of the
employees may participate in the purposes of section 125. See Rev. Rul. excess group-term life insurance (minus
cafeteria plan. The new proposed 2003–62 (2003–1 CB 1034) all after-tax contributions by the
regulations also require that all (distributions to former employees from employee for group-term life insurance
provisions of the written plan apply a qualified employees’ trust, applied to coverage) is includible in each covered
uniformly to all participants. pay health insurance premiums, are employee’s gross income. The new
includible in former employees’ gross proposed regulations provide that the
Individuals Who May Participate in a
income under section 402), see cost of group-term life insurance on the
Cafeteria Plan
§ 601.601(d)(2)(ii)(b). life of an employee, that either is less
All participants in a cafeteria plan than or equal to the amount excludible
must be employees. See section Qualified Benefits
from gross income under section 79(a)
125(d)(1)(A). These proposed In general, in order for a benefit to be or provides coverage in excess of that
regulations provide that employees a qualified benefit for purposes of amount, but not combined with any
include common law employees, leased section 125, the benefit must be permanent benefit, is a qualified benefit
employees described in section 414(n), excludible from employees’ gross that may be offered in a cafeteria plan.
and full-time life insurance salesmen (as income under a specific provision of the The new proposed regulations also
defined in section 7701(a)(20)). These Code and must not defer compensation, provide that the entire amount of salary
proposed regulations further provide except as specifically allowed in section reduction and employer flex-credits for
that former employees (including laid- 125(d)(2)(B), (C) or (D). Examples of group-term life insurance coverage on
off employees and retired employees) qualified benefits include the following: the life of an employee is excludible
may participate in a plan, but a plan group-term life insurance on the life of from an employee’s gross income.
may not be maintained predominantly an employee (section 79); employer- The rule in the new proposed
for former employees. See Rev. Rul. 82– provided accident and health plans, regulations differs from Notice 89–110
196 (1982–2 CB 53); Rev. Rul. 85–121 including health flexible spending (1989–2 CB 447), see
(1985–2 CB 57), see arrangements, and accidental death and § 601.601(d)(2)(ii)(b). Notice 89–110
§ 601.601(d)(2)(ii)(b). All employees dismemberment policies (sections 106 provides that an employee includes in
who are treated as employed by a single and 105(b)); a dependent care assistance gross income the greater of the Table I
employer under section 414(b), (c) or program (section 129); an adoption cost of group-term life insurance
(m) are treated as employed by a single assistance program (section 137); coverage exceeding $50,000 or the
employer for purposes of section 125. contributions to a section 401(k) plan; employee’s salary reduction and
See section 125(g)(4). A participant’s contributions to certain plans employer flex-credits for excess group-
spouse or dependents may receive maintained by educational term life insurance coverage. The new
benefits through a cafeteria plan organizations, and contributions to proposed regulations provide instead
although they cannot participate in the HSAs. Section 125(f), (d)(2)(B), (C), (D). that the employee includes in gross
cafeteria plan. See Notice 97–9 (1997–2 CB 35) income the Table I cost of the excess
Self-employed individuals are not (adoption assistance), see coverage (minus all after-tax
treated as employees for purposes of § 601.601(d)(2)(ii)(b); Notice 2004–2, Q contributions by the employee for
section 125. Accordingly, the new & A–33 (2004–1 CB 269) (HSAs), see group-term life insurance coverage) and
proposed regulations make clear that § 601.601(d)(2)(ii)(b). A cafeteria plan that the entire amount of salary
sole proprietors, partners, and directors may also offer long-term and short-term reduction and employer flex-credits for
of corporations are not employees and disability coverage as a qualified benefit group-term life insurance coverage on
may not participate in a cafeteria plan. (see section 106). However, see the life of the employee is excludible
In addition, the new proposed paragraph (q) in § 1.125–1 for from the employee’s gross income. As
regulations clarify that 2-percent nonqualified benefits. noted in this preamble, taxpayers may
shareholders of an S corporation are not rely on the new proposed regulations for
Group-Term Life Insurance
employees for purposes of section 125. guidance pending the issuance of final
The new proposed regulations provide An employer may provide group-term regulations.
rules for dual status individuals and life insurance through a combination of
individuals moving between employee methods. Generally, under section 79(a), Employer-Provided Accident and Health
and non-employee status. A self- the cost of $50,000 or less of group-term Plan
employed individual may, however, life insurance on the life of an employee Coverage under an employer-provided
sponsor a cafeteria plan for his or her provided under a policy (or policies) accident and health plan that satisfies
employees. carried directly or indirectly by an the requirements of section 105(b) may
employer is excludible from the be provided as a qualified benefit
Election Between Taxable and employee’s gross income. (Special rules through a cafeteria plan and is
Nontaxable Benefits apply to key employees if the group- excludible from employees’ gross
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The new proposed regulations require term life insurance plan does not satisfy income. Section 106; § 1.106–1. The
that a cafeteria plan offer employees an the nondiscrimination rules in section nondiscrimination rules under section
election among only permitted taxable 79(d)). However, if the group-term life 105(h) apply to self-insured medical
benefits (including cash) and qualified insurance provided to an employee by reimbursement arrangements (including
nontaxable benefits. See section an employer or employers exceeds health FSAs).
125(d)(1)(B). For purposes of section $50,000 (taking into account all The new proposed regulations
125, cash means cash from current coverage provided both through a specifically permit a cafeteria plan (but

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43941

not a health FSA) to pay or reimburse compensation. Section 125(d)(2)(A). In Grace Period
substantiated individual accident and general, benefits may not be carried over
health insurance premiums. See Rev. to a later plan year or used in one plan The new proposed regulations allow a
Rul. 61–146 (1961–2 CB 25), see year to purchase benefits to be provided written cafeteria plan to provide an
§ 601.601(d)(2)(ii)(b). In addition, a in a later plan year. For example, life optional grace period immediately
cafeteria plan may provide for payment insurance with a cash value build-up or following the end of each plan year,
of COBRA premiums for an employee. group-term life insurance with a extending the period for incurring
For employer-provided accident and permanent benefit (within the meaning expenses for qualified benefits. A grace
health plans and medical of § 1.79–0) defers the receipt of period may apply to one or more
reimbursement plans, the definition of compensation and thus is not a qualified benefits (for example, health
dependents is the definition in section qualified benefit. FSA or dependent care assistance
105(b) as amended by the Working The new proposed regulations clarify program) but in no event does it apply
Families Tax Relief Act of 2004 whether certain benefits and plan to paid time off or contributions to
(WFTRA), Public Law 108–311, section administration practices defer section 401(k) plans. Unused benefits or
207(9) (118 Stat. 1166) (that is, a compensation. For example, the contributions for one qualified benefit
dependent as defined in section 152, regulations permit an accident and may only be used to reimburse expenses
determined without regard to section health insurance policy to provide incurred during the grace period for that
152(b)(1), (b)(2), or (d)(1)(B)). See Notice certain benefit features that apply for same qualified benefit. The amount of
2004–79 (2004–2 CB 898), see more than one plan year, such as unused benefits and contributions
§ 601.601(d)(2)(ii)(b). For purposes of reasonable lifetime limits on benefits, available during the grace period may be
the exclusion from employees’ gross level premiums, premium waiver during limited by the employer. A grace period
income for accident and health plans disability, guaranteed renewability of may extend to the fifteenth day of the
and for medical reimbursement under coverage, coverage for specified third month after the end of the plan
sections 105(b) and 106, the spouse or accidental injury or specific diseases, year (but may be for a shorter period).
dependent of a former employee and the payment of a fixed amount per Benefits or contributions not used as of
(including a retired employee or a laid- day for hospitalization. But these the end of the grace period are forfeited
off employee) or of a deceased employee insurance policies must not provide an under the use-or-lose rule. The grace
is treated as a spouse or dependent. See investment fund or cash value to pay period applies to all employees who are
Rev. Rul. 82–196 (1982–2 CB 53); Rev. premiums, and no part of the premium participants (including through
Rul. 85–121 (1985–2 CB 57), see may be held in a separate account for COBRA), as of the last day of the plan
§ 601.601(d)(2)(ii)(b). any beneficiary. The new proposed year. Grace period rules must apply
regulations also provide that the uniformly to all participants. The grace
Dependent Care Assistance Programs following benefits and practices do not
and Adoption Assistance Programs period rules in these proposed
defer compensation: a long-term regulations are based on Notice 2005–42
If the requirements of section 129 are disability policy paying benefits over (2005–1 CB 1204), modified in Notice
satisfied, up to $5,000 of employer- more than one plan year; reasonable 2007–22 (2007–10 IRB 670), see
provided assistance for amounts paid or premium rebates or policy dividends; § 601.601(d)(2)(ii)(b), amplified in
incurred by employees for dependent certain two-year lock-in vision and Notice 2005–86 (2005–2 CB 1075),
care is excludible from employees’ gross dental policies; certain advance amplified in Notice 2007–22 (2007–10
income. The new proposed regulations payments for orthodontia; salary IRB 670), see § 601.601(d)(2)(ii)(b). For
outline the general requirements for reduction contributions in the last eligibility to contribute to a Health
providing dependent care assistance month of a plan year used to pay Savings Account (HSA) during a grace
programs and adoption assistance accident and health insurance period, see Notice 2005–86 (2005–2 CB
programs under section 137 through a premiums for the first month of the 1075), see § 601.601(d)(2)(ii)(b). For
cafeteria plan. See Notice 97–9, section following plan year; reimbursement of Form W–2 reporting for unused
II (1997–2 CB 35), see section 213(d) expenses for durable dependent care assistance used for
§ 601.601(d)(2)(ii)(b). medical equipment; and allocation of expenses incurred during a grace
experience gains (forfeitures) among period, see Notice 2005–61 (2005–2 CB
Cafeteria Plan Year participants. 607), see § 601.601(d)(2)(ii)(b).
The new proposed regulations require
Paid Time Off
that a cafeteria plan year must be 12 Contributions to Section 401(k) Plans
consecutive months and must be set out Under the prior proposed regulations, Through a Cafeteria Plan
in the written cafeteria plan. A short permitted taxable benefits included
plan year (or a change in plan year various forms of paid leave. Since the A cafeteria plan may include
resulting in a short plan year) is prior proposed regulations were issued, contributions to a section 401(k) plan.
permitted only for a valid business many employers have recharacterized Section 125(d)(2)(B). The new proposed
purpose. A change in plan year resulting and combined vacation days, sick leave regulations clarify the interactions
in a short plan year, for other than a and personal days into a single category between section 125 and section 401(k).
valid business purpose, is disregarded. of ‘‘paid time off.’’ The new proposed Contributions to a section 401(k) plan
If a principal purpose of a change in regulations use the term ‘‘paid time off’’ expressed as a percentage of
plan year is to circumvent the rules of to refer to vacation days and other types compensation are permitted. Pursuant
section 125, the change in plan year is of paid leave. The new proposed to § 1.401(k)–1(a)(3)(ii), elective
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ineffective. regulations contain the same ordering contributions to a section 401(k) plan
rule for elective and nonelective paid may be made through automatic
No Deferral of Compensation time off as set forth in Prop. § 1.125–1, enrollment (that is, when the employee
Qualified benefits must be current Q & A–7 (1984). A plan offering an does not affirmatively elect cash, the
benefits. In general, a cafeteria plan may election solely between paid time off employee’s compensation is reduced by
not offer benefits that defer and taxable benefits is not a cafeteria a fixed percentage, which is contributed
compensation or operate to defer plan. to a section 401(k) plan).

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43942 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

Nonqualified Benefits between taxable benefits and qualified revoke or change an employee’s
A cafeteria plan must not offer any of benefits. Elections must be made before election.
the following benefits: scholarships the earlier of the first day of the period
III. New Prop. § 1.125–5—Flexible
(section 117); employer-provided meals of coverage or when benefits are first
Spending Arrangements
and lodging (section 119); educational currently available. The determination
assistance (section 127); fringe benefits of whether a taxable benefit is currently Overview
(section 132); long-term care insurance. available does not depend on whether it In general, a flexible spending
See section 125(f). Long-term care has been constructively received by the arrangement (FSA) is a benefit designed
services are nonqualified benefits, H.R. employee for purposes of section 451. to reimburse employees for expenses
Conf. Rep. No. 736, 104th Cong., 2d Annual elections generally must be incurred for certain qualified benefits,
Sess. 29, reprinted in 1996 U.S.C.C.A.N. irrevocable and may not be changed up to a maximum amount not
2109. (An HSA funded through a during the plan year. However, § 1.125– substantially in excess of the salary
cafeteria plan may, however, be used to 4 permits a cafeteria plan to provide for reduction and employer flex-credits
pay premiums for long-term care changes in elections based on certain allocated for the benefit. The maximum
insurance or for long-term care changes in status. An employer that amount of reimbursement reasonably
services.) The new proposed regulations wishes to permit such changes in available must be less than five times
clarify that contributions to Archer elections must incorporate the rules in the value of the coverage. Employer
Medical Savings Accounts (sections § 1.125–4 in its written cafeteria plan. flex-credits are non-elective employer
220, 106(b)), group term life insurance These proposed regulations omit the contributions that an employer makes
for an employee’s spouse, child or rule in Q & A–6(b) in Prop. § 1.125–2 available for every employee eligible to
dependent, and elective deferrals to (1989) (cessation of required participate in the cafeteria plan, to be
section 403(b) plans are also contributions), because the change in used at the employee’s election only for
nonqualified benefits. A plan offering status rules in § 1.125–4 superseded this one or more qualified benefits (but not
any nonqualified benefit is not a provision of the 1989 proposed as cash or other taxable benefits). The
cafeteria plan. A cafeteria plan may not regulations. three types of FSAs are dependent care
offer a health FSA that provides for the If HSA contributions are made assistance, adoption assistance and
carryover of unused benefits. See Notice through salary reduction under a medical care reimbursements (health
2002–45, Part I (2002–2 CB 93); Rev. cafeteria plan, employees may FSA).
Rul. 2002–41 (2002–2 CB 75), see prospectively elect, revoke or change
Uniform Coverage Rule
§ 601.601(d)(2)(ii)(b). salary reduction elections for HSA
contributions at any time during the The new proposed regulations retain
After-Tax Employee Contributions plan year with respect to salary that has the rule that the maximum amount of
The new proposed regulations allow a not become currently available at the reimbursement from a health FSA must
cafeteria plan to offer after-tax employee time of the election. be available at all times during the
contributions for qualified benefits or A cafeteria plan is permitted to period of coverage (properly reduced as
paid time off. A cafeteria plan may only include an automatic election for new of any particular time for prior
offer the taxable benefits specifically employees or current employees. Rev. reimbursements). The uniform coverage
permitted in the new proposed Rul. 2002–27 (2002–1 CB 925), see rule does not apply to FSAs for
regulations. Nonqualified benefits may § 601.601(d)(2)(ii)(b). A new rule also dependent care assistance or adoption
not be offered through a cafeteria plan, permits a cafeteria plan to provide an assistance.
even if paid with after-tax employee optional election for new employees Use-or-Lose Rule
contributions. between cash and qualified benefits. An FSA must satisfy all the
New employees avoid gross income requirements of section 125, including
Employer Contributions Through Salary
inclusion if they make an election the prohibition against deferring
Reduction
within 30 days after the date of hire compensation. In general, as discussed
Employees electing a qualified benefit even if benefits provided pursuant to
through salary reduction are electing to under ‘‘No deferral of compensation’’, in
the election relate back to the date of order to satisfy this requirement of
forego salary and instead to receive a hire. However, salary reduction
benefit which is excludible from gross section 125, all benefits and
amounts used to pay for such an contributions must be used by the end
income because it is provided by election must be from compensation not
employer contributions. Section 125 of the plan year (or grace period, if
yet currently available on the date of the applicable), or are forfeited. The new
provides that the employee is treated as election. Also, this special election rule proposed regulations continue the use-
receiving the qualified benefit from the for new employees does not apply to or-lose rule.
employer in lieu of the taxable benefit. any employee who terminates
A cafeteria plan may also impose employment and is rehired within 30 Period of Coverage
reasonable fees to administer the days after terminating employment (or The required period of coverage for all
cafeteria plan which may be paid who returns to employment following FSAs continues to be twelve months,
through salary reduction. A cafeteria an unpaid leave of absence of less than with an exception for short plan years
plan is not required to allow employees 30 days). that satisfy the conditions in the new
to pay for any qualified benefit with New elections and revocations or proposed regulations. The period of
after-tax employee contributions. changes in elections can be made coverage and the plan year need not be
mstockstill on PROD1PC66 with PROPOSALS2

II. New Prop. § 1.125–2—Elections in electronically. The safe harbor for the same. The beginning and end of a
Cafeteria Plans electronic elections in § 1.401(a)–21 is period of coverage is clarified. The new
available. Only an employee can make proposed regulations also clarify that
Making, Revoking and Changing an election or revoke or change his or FSAs for different qualified benefits
Elections her election. An employee’s spouse or need not have the same coverage period.
Generally, a cafeteria plan must dependent may not make an election See also ‘‘Grace period’’, discussed in
require employees to elect annually under a cafeteria plan and may not this preamble. The new proposed

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43943

regulations also continue to provide that distributions set forth in Notice 2007–22 during a participant’s period of
expenses are incurred when services are (2007–10 IRB 670). See coverage.
provided. Expenses incurred before or § 601.601(d)(2)(ii)(b).
Substantiation and Reimbursement of
after the period of coverage may not be
Dependent Care Assistance After Expenses for Qualified Benefits
reimbursed.
Termination The new proposed regulations
Health FSA A new optional rule permits an provide, after an employee incurs an
A health FSA may only reimburse employer to reimburse a terminated expense for a qualified benefit during
certain substantiated section 213(d) employee’s qualified dependent care the coverage period, the expense must
medical care expenses incurred by the expenses incurred after termination first be substantiated before the expense
employee, or by the employee’s spouse through a dependent care FSA, if all may be paid or reimbursed. All
or dependents. A health FSA may be section 129 requirements are otherwise expenses must be substantiated
limited to a subset of permitted section satisfied. (substantiating only a limited number of
213(d) medical expenses (for example, a total claims, or not substantiating claims
Experience Gains
health FSA is permitted to exclude below a certain dollar amount does not
reimbursement of over-the-counter If an employee fails to use all satisfy the requirements in the new
drugs described in Rev. Rul. 2003–102 contributions and benefits for a plan proposed regulations). See § 1.105–2;
(2003–2 CB 559), see year before the end of the plan year (and Rul. 2003–80; Rev. Rul. 2003–43 (2002–
§ 601.601(d)(2)(ii)(b)). Similarly, a the grace period, if applicable), those 1 CB 935), see § 601.601(d)(2)(ii)(b);
health FSA may be an HSA-compatible unused contributions and benefits are Notice 2006–69 (2006–31 IRB 107),
limited-purpose health FSA or post- forfeited under the use-or-lose rule. Notice 2007–2 (2007–2 IRB 254). FSAs
deductible health FSA. Rev. Rul. 2004– Unused amounts are also known as for dependent care assistance and
45 (2004–1 CB 971), see experience gains. The new proposed adoption assistance must follow the
§ 601.601(d)(2)(ii)(b), amplified, Notice regulations retain the forfeiture substantiation procedures applicable to
2005–86 (2005–2 CB 1075). A health allocation rules in the 1989 proposed health FSAs.
FSA may not reimburse premiums for regulations, and clarify that the
employer sponsoring the cafeteria plan Debit Cards
accident and health insurance or long-
term care insurance. See section 125(f). may retain forfeitures, use forfeitures to The new proposed regulations
A health FSA must satisfy all defray expenses of administering the incorporate previously issued guidance
requirements of section 105(b), plan or allocate forfeitures among on substantiating, paying and
§§ 1.105–1 and 1.105–2. The section employees contributing through salary reimbursing expenses for section 213(d)
105(h) nondiscrimination rules apply to reduction on a reasonable and uniform medical care incurred at a medical care
health FSAs. All medical expenses must basis. provider when payment is made with a
be substantiated before expenses are debit card. Rev. Rul. 2003–43 (2003–1
FSA Administrative Rules
reimbursed. See Incurring and CB 935), amplified, Notice 2006–69
reimbursing expenses for qualified Salary reduction contributions may be (2006–31 IRB 107), Notice 2007–2
benefits, discussed in this preamble. made at whatever interval the employer (2007–2 IRB 254); Rev. Proc. 98–25
The new proposed regulations also selects, including ratably over the plan (1998–1 CB 689), see
clarify when medical expenses are year based on the employer’s payroll § 601.601(d)(2)(ii)(b). Among the
incurred.1 A cafeteria plan may limit periods or in equal installments at other permissible substantiation methods are
enrollment in a health FSA to those regular intervals (for example, quarterly copayment matches, recurring expenses,
employees who participate in the installments). These rules must apply and real-time substantiation. The new
employer’s accident and health plan. uniformly to all participants. proposed regulations also allow point-
IV. New Prop. § 1.125–6— of-sale substantiation through matching
Qualified HSA Distributions inventory information with a list of
Substantiation of Expenses for All
Section 106(e), enacted in section 302 Cafeteria Plans section 213(d) medical expenses. The
of the Health Opportunity Patient employer is responsible for ensuring
Empowerment Act of 2006, Public Law Incurring and Reimbursing Expenses for that the inventory information approval
109–432 (120 Stat. 2922 (2006)) allows Qualified Benefits system complies with the new
‘‘qualified HSA distributions’’ from The new proposed regulations regulations and with the recordkeeping
health FSAs to HSAs. Section 106(e) provide that only expenses for qualified requirements in section 6001. Rev. Rul.
applies to distributions between benefits incurred after the later of the 2003–43 (2003–1 CB 935), amplified,
December 20, 2006 and December 31, effective date or the adoption date of the Notice 2006–69 (2006–31 IRB 107),
2011. The proposed regulations cafeteria plan are permitted to be Notice 2007–2 (2007–2 IRB 254); Rev.
incorporate the rules on qualified HSA reimbursed under the cafeteria plan. Proc. 98–25 (1998–1 CB 689), see
Similarly, if a plan amendment adds a § 601.601(d)(2)(ii)(b). The new proposed
1 See Rev. Rul. 2005–55 (2005–2 CB 284) and Rev.
new qualified benefit, only expenses regulations also provide rules under
Rul. 2005–24 (2005–1 CB 892), see incurred after the later of the effective which an FSA may pay or reimburse
§ 601.601(d)(2)(ii)(b) (section 105(b) exclusion only
applicable to reimbursements for medical expenses date or the adoption date are eligible for dependent care expenses using debit
incurred by employee, or by the employee’s spouse reimbursement.2 This rule applies to all cards.
or dependents); Rev. Rul. 2002–3 (2002–1 CB 316) qualified benefits. Similarly, a cafeteria Pursuant to prior guidance (in Notice
(purported reimbursements to employees of health plan may pay or reimburse only 2006–69 (2006–31 IRB 107), amplified,
mstockstill on PROD1PC66 with PROPOSALS2

insurance premiums not paid by employees and


therefore impermissible); Rev. Rul. 2002–80 (2002– expenses for qualified benefits incurred Notice 2007–2 (2007–2 IRB 254)), for
2 CB 925), see § 601.601(d)(2)(ii)(b) (so-called plan years beginning after December 31,
advance reimbursements and purported loans are 2 See American Family Mut. Ins. Co. v. United 2006, the recordkeeping requirements
impermissible); Rev. Rul. 2003–43 (2003–1 CB 935), States, 815 F. Supp. 1206 (W.D. Wis. 1992); described in paragraph (f) in § 1.125–6
see § 601.601(d)(2)(ii)(b); Notice 2006–69 (2006–31 Wollenberg v. United States, 75 F. Supp.2d 1032 (D.
IRB 107) (substantiation requirements for debit Neb. 1999); Rev. Rul. 2002–58 (2002–2 CB 541), see
apply (that is, responsibility of
cards), amplified in Notice 2007–2 (2007–2 IRB § 601.601(d)(2)(ii)(b); Notice 97–9, section II employers relying on the inventory
254), see § 601.601(d)(2)(ii)(b). (adoption assistance). information approval system for health

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43944 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

FSA debit cards to ensure that the including highly compensated these proposed regulations remains
system complies with the new proposed individual or participant (consistent applicable through the effective date of
recordkeeping requirements, including with the section 414(q) definition of the final regulations (except as modified
Rev. Proc. 98–25 (1998–1 CB 689), highly compensated employee), officer, in ‘‘Effect on other documents’’ section
Notice 2006–69 (2006–31 IRB 107), five percent shareholder, key employee of this preamble).
amplified, Notice 2007–2 (2007–2 IRB and compensation. The new proposed
Effect on Other Documents
254). For health FSA debit card regulations also provide guidance on the
transactions occurring on or before nondiscrimination as to eligibility Notice 89–110 (1989–2 CB 447), see
December 31, 2007, all supermarkets, requirement by incorporating some of § 601.601(d)(2)(ii)(b), states that where
grocery stores, discount stores and the rules under section 410(b) group-term life insurance provided to an
wholesale clubs that do not have a (specifically the rules under § 1.410(b)– employee by an employer exceeds
medical care merchant category code (as 4(b) and (c) dealing with reasonable $50,000, the employee includes in gross
described in Rev. Rul. 2003–43 (2003– classification, the safe harbor percentage income the greater of the cost of group-
2 CB 935) are nevertheless deemed to be test and the unsafe harbor percentage term life insurance shown in § 1.79–
an ‘‘other medical provider’’ as component of the facts and 3(d)(2), Table I (Table I ) on the excess
described in Rev. Rul. 2003–43. (For a circumstances test). coverage or the employee’s salary
list of merchant category codes, see Rev. The new proposed regulations also reduction and employer flex-credits for
Proc. 2004–43 (2004–2 CB 124).) During provide additional guidance on the excess coverage. Notice 89–110 is
this time period, mail-order vendors and contributions and benefits test and, modified, effective as of the date the
web-based vendors that sell prescription unlike the prior proposed regulations, proposed regulations are published in
drugs are also deemed to be an ‘‘other the new proposed regulations provide the Federal Register.
medical provider’’ as described in Rev. an objective test to determine when the Published guidance under § 105(b)
Rul. 2003–43. After December 31, 2008, actual election of benefits is states that if any person has the right to
health FSA debit cards may not be used discriminatory. Specifically, the new receive cash or any other taxable or
at stores with the Drug Stores and proposed regulations provide that a nontaxable benefit under a health FSA
Pharmacies merchant category code cafeteria plan must give each similarly other than the reimbursement of section
unless (1) the store participates in the situated participant a uniform 213(d) medical expenses of the
inventory information approval system opportunity to elect qualified benefits, employee, employee’s spouse or
described in Notice 2006–69, or (2) on and that highly compensated employee’s dependents, then all
a store location by store location basis, participants must not actually distributions made from the
90 percent of the store’s gross receipts disproportionately elect qualified arrangement are included in the
during the prior taxable year consisted benefits. Finally, the new rules provide employee’s gross income, even amounts
of items which qualify as expenses for guidance on the safe harbor for cafeteria paid to reimburse medical care. See Rev.
medical care under section 213(d) plans providing health benefits and Rul. 2006–36 (2006–36 IRB 353); Rev.
(including nonprescription medications create a safe harbor for premium-only- Rul. 2005–24 (2005–1 CB 892); Rev. Rul.
described in Rev. Rul. 2003–102 (2003– plans that satisfy certain requirements. 2003–102 (2003–2 CB 559); Notice
2 CB 559)). Notice 2006–69 (2006–31 The example in Prop. § 1.125–1, Q & 2002–45 (2002–2 CB 93); Rev. Rul.
IRB 107), amplified, Notice 2007–2 A–11 (1984) is deleted because it 2002–41 (2002–2 CB 75); Rev. Rul. 69–
(2007–2 IRB 254). concerns a qualified legal services plan, 141 (1969–1 CB 48). New section 106(e)
which is no longer a qualified benefit. provides that a health FSA will not fail
V. New Prop. § 1.125–7— to satisfy the requirements of sections
Nondiscrimination Rules Other Issues 105 or 106 merely because the plan
Discriminatory benefits provided to These proposed regulations provide provides for a qualified HSA
highly compensated participants and guidance under section 125 (26 U.S.C. distribution. Amounts rolled into an
individuals and key employees are 125). Other statutes may impose HSA may be used for purposes other
included in these employees’ gross additional requirements (for example, than reimbursing the section 213(d)
income. See section 125(b), (c). The new the Employee Retirement Income medical expenses of the employee,
proposed regulations reflect changes in Security Act of 1974 (ERISA) (29 U.S.C. spouse or dependents. Accordingly,
tax law since Prop. § 1.125–1, Q & A– 1000), the Health Insurance Portability Rev. Rul. 2006–36, Rev. Rul. 2005–24,
9 through 13 and 19 were proposed in and Accountability Act of 1996 Rev. Rul. 2003–102, Notice 2002–45,
1984, including the key employee (HIPAA), (sections 9801–9803); and the Rev. Rul. 2002–41, and Rev. Rul. 69–141
concentration test, statutory nontaxable continuation coverage requirements are modified with respect to qualified
benefits (enacted in the Deficit under the Consolidated Omnibus HSA distributions described in section
Reduction Act of 1984 (DEFRA), Public Budget Reconciliation Act of 1985 106(e). See Notice 2007–22 (2007–10
Law 98–369, section 531(b), (98 Stat. (COBRA) (section 4980B). IRB 670), see § 601.601(d)(2)(ii)(b).
881(1984)), and the change in definition
Proposed Effective Date Special Analyses
of dependent in WFTRA.
The new proposed regulations With the exceptions noted in the It has been determined that this notice
provide additional guidance on the ‘‘Effect on other documents’’ section of of proposed rulemaking is not a
cafeteria plan nondiscrimination rules, this preamble and under the ‘‘Debit significant regulatory action as defined
including definitions of key terms, cards’’ section of the preamble, it is in Executive Order 12866. Therefore, a
guidance on the eligibility test and the proposed that these regulations apply regulatory assessment is not required. It
mstockstill on PROD1PC66 with PROPOSALS2

contributions and benefits tests, for plan years beginning on or after also has been determined that section
descriptions of employees allowed to be January 1, 2009. Taxpayers may rely on 553(b) of the Administrative Procedure
excluded from testing and a safe harbor these regulations for guidance pending Act (5 U.S.C. chapter 5) does not apply
nondiscrimination test for premium- the issuance of final regulations. Prior to this regulation. It is hereby certified
only-plans. published guidance on qualified that the collection of information in this
Specifically, the new proposed benefits under sections 79, 105, 106, regulation will not have a significant
regulations define several key terms, 129, 137 and 223 that is affected by economic impact on a substantial

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43945

number of small entities. This Revenue Service, 1111 Constitution PART 1—INCOME TAXES
certification is based on the fact that the Avenue, NW., Washington, DC. Due to
regulations will only minimally increase building security procedures, visitors Paragraph 1. The authority citation
the burdens on small entities. The must enter at the Constitution Avenue for part 1 continues to read, in part, as
requirements under these regulations entrance. In addition, all visitors must follows:
relating to maintaining a section 125 present photo identification to enter the Authority: 26 U.S.C. 7805 * * *
cafeteria plan are a minimal additional building. Because of access restrictions, Par. 2. Sections 1.125–0, 1.125–1 and
burden independent of the burdens visitors will not be admitted beyond the 1.125–2 are added to read as follows:
encompassed under existing rules for immediate entrance area more than 30
underlying employee benefit plans, minutes before the hearing starts. For § 1.125–0 Table of contents.
which exist whether or not the benefits information about having your name This section lists captions contained
are provided through a cafeteria plan. In placed on the building access list to in §§ 1.125–1, 1.125–2, 1.125–5, 1.125–
addition, most small entities that will attend the hearing, see the FOR FURTHER 6 and § 1.125–7.
maintain cafeteria plans already use a INFORMATION CONTACT section of this
third-party plan administrator to § 1.125–1 Cafeteria plans; general rules.
preamble.
administer the cafeteria plan. The The rules of 26 CFR 601.601(a)(3) (a) Definitions.
collection of information required in apply to the hearing. Persons who wish (b) General rules.
these regulations, which is required to (c) Written plan requirements.
to present oral comments at the hearing (d) Plan year requirements.
comply with the existing substantiation must submit written or electronic (e) Grace period.
requirements of sections 105, 106, 129 comments and an outline of the topics (f) Run-out period.
and 125, and the recordkeeping to be discussed and the amount of time (g) Employee for purpose of Section 125.
requirements of section 6001, will only to be devoted to each topic (a signed (h) After-tax employee contributions.
minimally increase the third-party original and eight (8) copies) by October (i) Prohibited taxable benefits.
administrator’s burden with respect to 25, 2007. A period of 10 minutes will (j) Coordination with other rules.
the cafeteria plan. Therefore, an analysis (k) Group-term life insurance.
be allotted to each person for making (l) COBRA premiums.
under the Regulatory Flexibility Act (5 comments. An agenda showing the (m) Payment or reimbursement of employees’
U.S.C. chapter 6) is not required. scheduling of the speakers will be individual accident and health insurance
Pursuant to section 7805(f) of the prepared after the deadline for receiving premiums.
Internal Revenue Code, this proposed outlines has passed. Copies of the (n) Section 105 rules for accident and health
regulation has been submitted to the agenda will be available free of charge plan offered through a cafeteria plan.
Chief Counsel for Advocacy of the Small at the hearing. (o) Prohibition against deferred
Business Administration for comment compensation.
on its impact on small business. Drafting Information (p) Benefits relating to more than one year.
(q) Nonqualified benefits.
The principal author of these (r) Employer contributions to a cafeteria plan.
Comments and Public Hearing
proposed regulations is Mireille T. (s) Effective/applicability date.
Before these proposed regulations are Khoury, Office of Division Counsel/
adopted as final regulations, Associate Chief Counsel (Tax Exempt § 1.125–2 Cafeteria plans; elections.
consideration will be given to any and Government Entities), Internal (a) Rules relating to making elections and
written comments (a signed original and Revenue Service. However, personnel revoking elections.
eight (8) copies) or electronic comments from other offices of the IRS and (b) Automatic elections.
that are submitted timely to the IRS. The Treasury Department participated in (c) Election rules for salary reduction
IRS and Treasury Department their development. contributions to HSAs.
specifically request comments on the (d) Optional election for new employees.
clarity of the proposed rules and how List of Subjects in 26 CFR Part 1 (e) Effective/applicability date.
they can be made easier to understand. Income taxes, Reporting and § 1.125–5 Flexible spending arrangements.
In addition, comments are requested on recordkeeping requirements. (a) Definition of flexible spending
the following issues: arrangement.
Withdrawal of Proposed Regulations
1. Whether, consistent with section (b) Flex-credits allowed.
125 of the Internal Revenue Code, Accordingly, under the authority of (c) Use-or-lose rule.
multiple employers (other than 26 U.S.C. 7805, the notice of proposed (d) Uniform coverage rules applicable to
members of a controlled group rulemaking (EE–16–79) that was health FSAs.
described in section 125(g)(4)) may published in the Federal Register on (e) Required period of coverage for a health
sponsor a single cafeteria plan; Monday, May 7, 1984 (49 FR 19321), FSA, dependent care FSA and adoption
2. Whether salary reduction and Monday, December 31, 1984 (49 FR assistance FSA.
(f) Coverage on a month-by-month or
contributions may be based on 50733), the notice of proposed
expense-by-expense basis prohibited.
employees’ tips and how that would rulemaking (EE–130–86) that was (g) FSA administrative practices.
work; published in the Federal Register on (h) Qualified benefits permitted to be offered
3. For cafeteria plans adopting the Tuesday, March 7, 1989 (54 FR 9460), through a FSA.
change in status rules in § 1.125–4, and Friday, November 7, 1997 (62 FR (i) Section 129 rules for dependent care
when a participant has a change in 60196) and the notice of proposed assistance program offered through a
status and changes his or her salary rulemaking (REG–117162–99) that was cafeteria plan.
reduction amount, how should the published in the Federal Register on (j) Section 137 rules for adoption assistance
mstockstill on PROD1PC66 with PROPOSALS2

participant’s uniform coverage amount program offered through a cafeteria plan.


Thursday, March 23, 2000 (65 FR
(k) FSAs and the rules governing the tax-
be computed after the change in status. 15587) are withdrawn. favored treatment of employer-provided
All comments will be available for health benefits.
public inspection and copying. Proposed Amendment to the
Regulations (l) Section 105(h) requirements.
A public hearing has been scheduled (m) HSA-compatible FSAs-limited-purpose
for November 15, 2007, beginning at 10 Accordingly, 26 CFR part 1 is health FSAs and post-deductible health
a.m. in the Auditorium, Internal proposed to be amended as follows: FSAs.

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(n) Qualified HSA distributions. benefits treated as cash for purposes of (H) A qualified cash or deferred
(o) FSA experience gains or forfeitures. section 125. For purposes of section arrangement that is part of a profit-
(p) Effective/applicability date. 125, cash means cash compensation sharing plan or stock bonus plan, as
§ 1.125–6 Substantiation of expenses for (including salary reduction), payments described in paragraph (o)(3) of this
all cafeteria plans. for annual leave, sick leave, or other section (section 401(k));
paid time off and severance pay. A (I) Certain plans maintained by
(a) Cafeteria plan payments and
reimbursements. distribution from a trust described in educational organizations (section
(b) Rules for claims substantiation for section 401(a) is not cash for purposes 125(d)(2)(C) and paragraph (o)(3)(iii) of
cafeteria plans. of section 125. Other taxable benefits this section); and
(c) Debit cards—overview. treated as cash for purposes of section (J) Contributions to Health Savings
(d) Mandatory rules for all debit cards usable 125 are: Accounts (HSAs) (sections 223 and
to pay or reimburse medical expenses. (i) Property; 125(d)(2)(D)).
(e) Substantiation of expenses incurred at (ii) Benefits attributable to employer (4) Dependent. The term dependent
medical care providers and certain other
contributions that are currently taxable generally means a dependent as defined
stores with Drug Stores and Pharmacies in section 152. However, the definition
merchant category code. to the employee upon receipt by the
employee; and of dependent is modified to conform
(f) Inventory information approval system. with the underlying Code section for the
(g) Debit cards used to pay or reimburse (iii) Benefits purchased with after-tax
employee contributions, as described in qualified benefit. For example, for
dependent care assistance.
purposes of a benefit under section 105,
(h) Effective/applicability date. paragraph (h) of this section.
the term dependent means a dependent
(3) Qualified benefit. Except as
§ 1.125–7 Cafeteria plan nondiscrimination as defined in section 152, determined
otherwise provided in section 125(f) and
rules. without regard to section 152(b)(1),
paragraph (q) of this section, the term
(a) Definitions. (b)(2) or (d)(1)(B).
qualified benefit means any benefit (5) Premium-only-plan. A premium-
(b) Nondiscrimination as to eligibility.
(c) Nondiscrimination as to contributions and
attributable to employer contributions to only-plan is a cafeteria plan that offers
benefits. the extent that such benefit is not as its sole benefit an election between
(d) Key employees. currently taxable to the employee by cash (for example, salary) and payment
(e) Section 125(g)(2) safe harbor for cafeteria reason of an express provision of the of the employee share of the employer-
plans providing health benefits. Internal Revenue Code (Code) and provided accident and health insurance
(f) Safe harbor test for premium-only-plans. which does not defer compensation premium (excludible from the
(g) Permissive disaggregation for (except as provided in paragraph (o) of
nondiscrimination testing. employee’s gross income under section
this section). The following benefits are 106).
(h) Optional aggregation of plans for qualified benefits that may be offered
nondiscrimination testing. (b) General rules—(1) Cafeteria plans.
(i) Employees of certain controlled groups.
under a cafeteria plan and are Section 125 is the exclusive means by
(j) Time to perform nondiscrimination excludible from employees’ gross which an employer can offer employees
testing. income when provided in accordance an election between taxable and
(k) Discrimination in actual operation with the applicable provisions of the nontaxable benefits without the election
prohibited. Code— itself resulting in inclusion in gross
(l) Anti-abuse rule. (A) Group-term life insurance on the income by the employees. Section 125
(m) Tax treatment of benefits in a cafeteria life of an employee in an amount that provides that cash (including certain
plan. is less than or equal to the $50,000 taxable benefits) offered to an employee
(n) Employer contributions to employees’ excludible from gross income under
Health Savings Accounts. through a nondiscriminatory cafeteria
(o) Effective/applicability date.
section 79(a), but not combined with plan is not includible in the employee’s
any permanent benefit within the gross income merely because the
§ 1.125–1 Cafeteria plans; general rules. meaning of § 1.79–0; employee has the opportunity to choose
(a) Definitions. The definitions set (B) An accident and health plan among cash and qualified benefits
forth in this paragraph (a) apply for excludible from gross income under (within the meaning of section 125(e))
purposes of section 125 and the section 105 or 106, including self- through the cafeteria plan. Section
regulations. insured medical reimbursement plans 125(a), (d)(1). However, if a plan
(1) The term cafeteria plan means a (such as health FSAs described in offering an employee an election
separate written plan that complies with § 1.125–5); between taxable benefits (including
the requirements of section 125 and the (C) Premiums for COBRA cash) and nontaxable qualified benefits
regulations, that is maintained by an continuation coverage (if excludible does not meet the section 125
employer for the benefit of its under section 106) under the accident requirements, the election between
employees and that is operated in and health plan of the employer taxable and nontaxable benefits results
compliance with the requirements of sponsoring the cafeteria plan or in gross income to the employee,
section 125 and the regulations. All premiums for COBRA continuation regardless of what benefit is elected and
participants in a cafeteria plan must be coverage of an employee of the when the election is made. An
employees. A cafeteria plan must offer employer sponsoring the cafeteria plan employee who has an election among
at least one permitted taxable benefit (as under an accident and health plan nontaxable benefits and taxable benefits
defined in paragraph (a)(2) of this sponsored by a different employer; (including cash) that is not through a
section) and at least one qualified (D) An accidental death and cafeteria plan that satisfies section 125
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benefit (as defined in paragraph (a)(3) of dismemberment insurance policy must include in gross income the value
this section). A cafeteria plan must not (section 106); of the taxable benefit with the greatest
provide for deferral of compensation (E) Long-term or short-term disability value that the employee could have
(except as specifically permitted in coverage (section 106); elected to receive, even if the employee
paragraph (o) of this section). (F) Dependent care assistance elects to receive only the nontaxable
(2) The term permitted taxable benefit program (section 129); benefits offered. The amount of the
means cash and certain other taxable (G) Adoption assistance (section 137); taxable benefit is includible in the

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employee’s income in the year in which (4) Election by participants—(i) In part of the enrollment process. If the
the employee would have actually general. A cafeteria plan must offer employee has a spouse or child, the
received the taxable benefit if the participants the opportunity to elect employee can elect between cash and family
employee had elected such benefit. This between at least one permitted taxable coverage.
(iii) When an employee is hired, the
is the result even if the employee’s benefit and at least one qualified employee receives a notice explaining the
election between the nontaxable benefit. For example, if employees are plan’s automatic enrollment process. The
benefits and taxable benefits is made given the opportunity to elect only notice includes the salary reduction amounts
prior to the year in which the employee among two or more nontaxable benefits, for employee-only coverage and family
would actually have received the the plan is not a cafeteria plan. coverage, procedures for certifying whether
taxable benefits. See paragraph (q) in Similarly, a plan that only offers the the employee has other health coverage,
§ 1.125–1 for nonqualified benefits. election among salary, permitted taxable elections for family coverage, information on
benefits, paid time off or other taxable the time by which a certification or election
(2) Nondiscrimination rules for
benefits is not a cafeteria plan. See must be made, and the period for which a
qualified benefits. Accident and health certification or election will be effective. The
plan coverage, group-term life insurance section 125(a), (d). See § 1.125–2 for notice is also given to each current employee
coverage, and benefits under a rules on elections. before the beginning of each plan year,
dependent care assistance program or (ii) Premium-only-plan. A cafeteria (except that the notice for a current employee
adoption assistance program do not fail plan may be a premium-only-plan. includes a description of the employee’s
to be qualified benefits under a cafeteria (iii) Examples. The following existing coverage, if any).
plan merely because they are includible examples illustrate the rules of (iv) For a new employee, an election to
in gross income because of applicable paragraph (b)(4)(i) of this section. receive cash or to have family coverage is
effective if made when the employee is hired.
nondiscrimination requirements (for Example 1. No election. Employer C covers
For a current employee, an election is
example, sections 79(d), 105(h),129(d), all its employees under its accident and
effective if made prior to the start of each
137(c)(2)). See also §§ 1.105–11(k) and health plan (excludible from employees’
gross income under section 106). Coverage is calendar year or under any other
1.125–7. circumstances permitted under § 1.125–4. An
mandatory (that is, employees have no
(3) Examples. The following examples election between cash and the Employer C’s election for any prior year carries over to the
illustrate the rules of paragraph (b)(1) of accident and health plan). This plan is not next succeeding plan year unless changed.
this section. a cafeteria plan, because the plan offers Certification that the employee has other
employees no election between taxable and health coverage must be made annually.
Example 1. Distributions from qualified (v) Contributions used to purchase
pension plan used for health insurance nontaxable benefits. The accident and health
coverage is excludible from employees’ gross employer-provided accident and health
premiums. (i) Employer A maintains a coverage under section 125 are not includible
qualified section 401(a) retirement plan for income.
Example 2. Election between cash and at in an employee’s gross income if the
employees. Employer A also provides employee can elect cash. Section 125 does
least one qualified benefit. Employer D offers
accident and health insurance (as described not apply to the employee-only coverage of
its employees a plan with an election
in section 106) for employees and former an employee who cannot certify that he or
between cash and an employer-provided
employees, their spouses and dependents. she has other health coverage and, therefore,
accident and health plan (excludible from
The health insurance premiums are partially does not have the ability to elect cash in lieu
employees’ gross income under section 106).
paid through a cafeteria plan. None of of health coverage.
If the plan also satisfies all the other
Employer A’s employees are public safety
requirements of section 125, the plan is a (5) No deferred compensation. Except
officers. Employer A’s health plan allows
cafeteria plan because it offers an election as provided in paragraph (o) of this
former employees to elect to have
between at least one taxable benefit and at section, in order for a plan to be a
distributions from the qualified retirement
least one nontaxable qualified benefit.
plan applied to pay for the health insurance
Example 3. Election between employer
cafeteria plan, the qualified benefits and
premiums through the cafeteria plan. the permitted taxable benefits offered
flex-credits and qualified benefits. Employer
(ii) Amounts distributed from the qualified through the cafeteria plan must not
E offers its employees an election between an
retirement plan which the former employees defer compensation. For example, a
employer flex-credit (as defined in paragraph
elect to have applied to pay health insurance
(b) in § 1.125–5) and qualified benefits. If an cafeteria plan may not provide for
premiums through the cafeteria plan are
includible in their gross income. The same
employee does not elect to apply the entire retirement health benefits for current
employer flex-credit to qualified benefits, the employees beyond the current plan year
result occurs if distributions from the
employee will receive no cash or other or group-term life insurance with a
qualified retirement plan are applied directly
taxable benefit for the unused employer flex- permanent benefit, as defined under
to reimburse section 213(d) medical care
credit. The plan is not a cafeteria plan
expenses incurred by a former employee or § 1.79–0.
because it does not offer an election between
his or her spouse or dependents. These (c) Written plan requirements—(1)
at least one taxable benefit and at least one
distributions are includible in their income, General rule. A cafeteria plan must
nontaxable qualified benefit.
and are not cash for purposes of section 125. contain in writing the information
Example 4. No election between cash and
The plan is not a cafeteria plan with respect described in this paragraph (c), and
qualified benefits for certain employees. (i)
to former employees.
Example 2. Severance pay used to pay
Employer F maintains a calendar year plan depending on the qualified benefits
offering employer-provided accident and offered in the plan, may also be required
COBRA premiums. Employer B maintains a
health insurance coverage which includes to contain additional information
cafeteria plan, which offers employees an
employee-only and family coverage options. described in paragraphs (c)(2) and (c)(3)
election between cash and employer-
provided accident and health insurance (ii) The plan provides for an automatic of this section. The cafeteria plan must
(excludible from employees’ gross income enrollment process when a new employee is be adopted and effective on or before
under section 106). Employer B pays hired, or during the annual election period the first day of the cafeteria plan year to
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terminating employees severance pay. The under the plan: only employees who certify which it relates. The terms of the plan
cafeteria plan also allows a terminating that they have other health coverage are must apply uniformly to all
employee to elect between receiving permitted to elect to receive cash. Employees
severance pay and using the severance pay to who cannot certify are covered by the
participants. The cafeteria plan
pay the COBRA premiums for the accident accident and health insurance on a document may be comprised of multiple
and health insurance. These provisions in the mandatory basis. Employer F does not documents. The written cafeteria plan
cafeteria plan are consistent with the otherwise request or collect information from must contain all of the following
requirements in section 125. employees regarding other health coverage as information—

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(i) A specific description of each of 11(b)(1)(i)), dependent care assistance (7) Operational failure—(i) In general.
the benefits available through the plan, programs (section 129(d)(1)), and If the cafeteria plan fails to operate
including the periods during which the adoption assistance (section 137(c)). according to its written plan or
benefits are provided (the periods of Any of these plans or programs offered otherwise fails to operate in compliance
coverage); through a cafeteria plan that satisfies the with section 125 and the regulations,
(ii) The plan’s rules governing written plan requirement in this the plan is not a cafeteria plan and
participation, and specifically requiring paragraph (c) for the benefits under employees’ elections between taxable
that all participants in the plan be these plans and programs also satisfies and nontaxable benefits result in gross
employees; the written plan requirements in income to the employees.
(iii) The procedures governing § 1.105–11(b)(1)(i), section 129(d)(1), (ii) Failure to operate according to
employees’ elections under the plan, and section 137(c) (whichever is written cafeteria plan or section 125.
including the period when elections applicable). Alternatively, a self-insured Examples of failures resulting in section
may be made, the periods with respect medical reimbursement plan, a 125 not applying to a plan include the
to which elections are effective, and dependent care assistance program, or following—
providing that elections are irrevocable, an adoption assistance program is (A) Paying or reimbursing expenses
except to the extent that the optional permitted to satisfy the requirements in for qualified benefits incurred before the
change in status rules in § 1.125–4 are § 1.105–11(b)(1)(i), section 129(d)(1), or later of the adoption date or effective
included in the cafeteria plan; section 137(c) (whichever is applicable) date of the cafeteria plan, before the
(iv) The manner in which employer through a separate written plan, and not beginning of a period of coverage or
contributions may be made under the as part of the written cafeteria plan. before the later of the date of adoption
plan, (for example, through an (3) Additional requirements under or effective date of a plan amendment
employee’s salary reduction election or section 401(k). See § 1.401(k)–1(e)(7) for adding a new benefit;
by nonelective employer contributions additional requirements that must be (B) Offering benefits other than
(that is, flex-credits, as defined in satisfied in the written plan if the plan permitted taxable benefits and qualified
paragraph (b) in § 1.125–5) or both); offers deferrals into a section 401(k) benefits;
(v) The maximum amount of plan. (C) Operating to defer compensation
employer contributions available to any (4) Cross-reference allowed. In (except as permitted in paragraph (o) of
employee through the plan, by stating: describing the benefits available through this section);
(A) The maximum amount of elective the cafeteria plan, the written cafeteria (D) Failing to comply with the
contributions (i.e., salary reduction) plan need not be self-contained. For uniform coverage rule in paragraph (d)
available to any employee through the example, the written cafeteria plan may in § 1.125–5;
plan, expressed as a maximum dollar (E) Failing to comply with the use-or-
incorporate by reference benefits offered
amount or a maximum percentage of lose rule in paragraph (c) in § 1.125–5;
through other separate written plans,
compensation or the method for (F) Allowing employees to revoke
such as a section 401(k) plan, or
determining the maximum dollar elections or make new elections, except
coverage under a dependent care
amount; and as provided in § 1.125–4 and paragraph
assistance program (section 129),
(B) For contributions to section 401(k) (a) in § 1.125–2;
without describing in full the benefits (G) Failing to comply with the
plans, the maximum amount of elective
established through these other plans. substantiation requirements of § 1.125–
contributions available to any employee
But, for example, if the cafeteria plan 6;
through the plan, expressed as a
offers different maximum levels of (H) Paying or reimbursing expenses in
maximum dollar amount or maximum
coverage for dependent care assistance an FSA other than expenses expressly
percentage of compensation that may be
programs, the descriptions in the permitted in paragraph (h) in § 1.125–5;
contributed as elective contributions
separate written plan must specify the (I) Allocating experience gains other
through the plan by employees.
(vi) The plan year of the cafeteria available maximums. than as expressly permitted in
plan; (5) Amendments to cafeteria plan. paragraph (o) in § 1.125–5;
(vii) If the plan offers paid time off, Any amendment to the cafeteria plan (J) Failing to comply with the grace
the required ordering rule for use of must be in writing. A cafeteria plan is period rules in paragraph (e) of this
nonelective and elective paid time off in permitted to be amended at any time section; or
paragraph (o)(4) of this section; during a plan year. However, the (K) Failing to comply with the
(viii) If the plan includes flexible amendment is only permitted to be qualified HSA distribution rules in
spending arrangements (as defined in effective for periods after the later of the paragraph (n) in § 1.125–5.
§ 1.125–5(a)), the plan’s provisions adoption date or effective date of the (d) Plan year requirements—(1)
complying with any additional amendment. For an amendment adding Twelve consecutive months. The plan
requirements for those FSAs (for a new benefit, the cafeteria plan must year must be specified in the cafeteria
example, the uniform coverage rule and pay or reimburse only those expenses plan. The plan year of a cafeteria plan
the use-or-lose rules in paragraphs (d) for new benefits incurred after the later must be twelve consecutive months,
and (c) in § 1.125–5); of the amendment’s adoption date or unless a short plan year is allowed
(ix) If the plan includes a grace effective date. under this paragraph (d). A plan year is
period, the plan’s provisions complying (6) Failure to satisfy written plan permitted to begin on any day of any
with paragraph (e) of this section; and requirements. If there is no written calendar month and must end on the
(x) If the plan includes distributions cafeteria plan, or if the written plan fails preceding day in the immediately
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from a health FSA to employees’ HSAs, to satisfy any of the requirements in this following year (for example, a plan year
the plan’s provisions complying with paragraph (c) (including cross- that begins on October 15, 2007, must
paragraph (n) in § 1.125–5. referenced requirements), the plan is not end on October 14, 2008). A calendar
(2) Additional requirements under a cafeteria plan and an employee’s year plan year is a period of twelve
sections 105(h), 129, and 137. A written election between taxable and nontaxable consecutive months beginning on
plan is required for self-insured medical benefits results in gross income to the January 1 and ending on December 31
reimbursement plans (§ 1.105– employee. of the same calendar year. A plan year

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specified in the cafeteria plan is expenses for that same qualified benefit requirements in paragraph (c) of this
effective for the first plan year of a during the grace period, may be paid or section and all of the following
cafeteria plan and for all subsequent reimbursed for those expenses from the requirements:
plan years, unless changed as provided unused benefits or contributions as if (i) The grace period provisions in the
in paragraph (d)(2) of this section. the expenses had been incurred in the cafeteria plan (including optional
(2) Changing plan year. The plan year immediately preceding plan year. A provisions in paragraph (e)(2) of this
is permitted to be changed only for a grace period is available for all qualified section) must apply uniformly to all
valid business purpose. A change in the benefits described in paragraph (a)(3) of participants in the cafeteria plan,
plan year is not permitted if a principal this section, except that the grace period determined as of the last day of the plan
purpose of the change in plan year is to does not apply to paid time off and year. Participants in the cafeteria plan
circumvent the rules of section 125 or elective contributions under a section through COBRA and participants who
these regulations. If a change in plan 401(k) plan. The effect of the grace were participants as of the last day of
year does not satisfy this subparagraph, period is that the employee may have as the plan year but terminate during the
the attempt to change the plan year is long as 14 months and 15 days (that is, grace period are participants for
ineffective and the plan year of the the 12 months in the current cafeteria purposes of the grace period. See
cafeteria plan remains the same. plan year plus the grace period) to use § 54.4980B–2, Q & A–8 of this chapter;
(3) Short plan year. A short plan year the benefits or contributions for a plan (ii) The grace period provision in the
of less than twelve consecutive months year before those amounts are forfeited cafeteria plan must state that unused
is permitted for a valid business under the use-or-lose rule in paragraph benefits or contributions relating to a
purpose. (c) in § 1.125–5. If the grace period is particular qualified benefit may only be
(4) Examples. The following examples added to a cafeteria plan through an used to pay or reimburse expenses
illustrate the rules in paragraph (d) of amendment, all requirements in incurred with respect to the same
this section: paragraph (c) of this section must be qualified benefit. For example, unused
Example 1. Employer with calendar year. satisfied. amounts elected to pay or reimburse
Employer G, with a calendar taxable year, (2) Grace period optional features. A medical expenses in a health FSA may
first establishes a cafeteria plan effective July grace period provision may contain any not be used to pay or reimburse
1, 2009. The cafeteria plan specifies a or all of the following— dependent care expenses incurred
calendar plan year. The first cafeteria plan (i) The grace period may apply to during the grace period; and
year is the period beginning on July 1, 2009, some qualified benefits described in
and ending on December 31, 2009. Employer
(iii) The grace period provision in the
paragraph (a)(3) of this section, but not cafeteria plan must state that to the
G has a business purpose for a short first to others;
cafeteria plan year. extent any unused benefits or
(ii) The grace period provision may contributions from the immediately
Example 2. Employer changes insurance
carrier. Employer H establishes a cafeteria limit the amount of unused benefits or preceding plan year exceed the
plan effective January 1, 2009, with a contributions available during the grace expenses for the qualified benefit
calendar year plan year. The cafeteria plan period. The limit must be uniform and incurred during the grace period, those
offers an accident and health plan through apply to all participants. However, the remaining unused benefits or
Insurer X. In March 2010, Employer H limit must not be based on a percentage contributions may not be carried
contracts to provide accident and health of the amount of the unused benefits or
insurance through another insurance forward to any subsequent period
contributions remaining at the end of (including any subsequent plan year),
company, Y. Y’s accident and health the immediately prior plan year;
insurance is offered on a July 1–June 30 cannot be cashed-out and must be
(iii) The last day of the grace period
benefit year. Effective July 1, 2010, Employer forfeited under the use-or-lose rule. See
H amends the plan to change to a July 1–June may be sooner than the fifteenth day of
paragraph (c) in § 1.125–5
30 plan year. Employer H has a business the third month immediately following
(4) Examples. The following examples
purpose for changing the cafeteria plan year the end of the plan year (that is, the
illustrate the rules in this paragraph (e).
and for the short plan year ending June 30, grace period may be shorter than two Example 1. Expenses incurred during grace
2010. and one half months); period and immediately following plan year.
(5) Significance of plan year. The plan (iv) The grace period provision is (i) Employer I’s calendar year cafeteria plan
year generally is the coverage period for permitted to treat expenses for qualified includes a grace period allowing all
benefits provided through the cafeteria benefits incurred during the grace participants to apply unused benefits or
plan to which annual elections for these period either as expenses incurred contributions remaining at the end of the
benefits apply. Benefits elected during the immediately preceding plan plan year to qualified benefits incurred
pursuant to the employee’s election for year or as expenses incurred during the during the grace period immediately
a plan year generally may not be carried current plan year (for example, the plan following that plan year. The grace period for
forward to subsequent plan years. the plan year ending December 31, 2009,
may first apply the unused ends on March 15, 2010.
However, see the grace period rule in contributions or benefits from the (ii) Employee X timely elected salary
paragraph (e) of this section. immediately preceding year to pay or reduction of $1,000 for a health FSA for the
(e) Grace period—(1) In general. A reimburse grace period expenses and plan year ending December 31, 2009. As of
cafeteria plan may, at the employer’s then, when the unused contributions December 31, 2009, X has $200 remaining
option, include a grace period of up to and benefits from the prior year are unused in his health FSA. X timely elected
the fifteenth day of the third month exhausted, the grace period expenses salary reduction for a health FSA of $1,500
immediately following the end of each may be paid from current year for the plan year ending December 31, 2010.
plan year. If a cafeteria plan provides for contributions and benefits.); and (iii) During the grace period from January
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a grace period, an employee who has (v) The grace period provision may 1 through March 15, 2010, X incurs $300 of
unused benefits or contributions unreimbursed medical expenses (as defined
permit the employer to defer the in section 213(d)). The unused $200 from the
relating to a qualified benefit (for allocation of expenses described in plan year ending December 31, 2009, is
example, health flexible spending paragraph (e)(2)(iv) of this section until applied to pay or reimburse $200 of X’s $300
arrangement (health FSA) or dependent after the end of the grace period. of medical expenses incurred during the
care assistance) from the immediately (3) Grace period requirements. A grace period. Therefore, as of March 16, 2010,
preceding plan year, and who incurs grace period must satisfy the X has no unused benefits or contributions

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remaining for the plan year ending December (f) Run-out period. A cafeteria plan is cafeteria plan solely in his or her
31, 2009. permitted to contain a run-out period as capacity as an employee. This rule does
(iv) The remaining $100 of medical designated by the employer. A run-out not apply to partners or to 2-percent
expenses incurred between January 1 and
period is a period after the end of the shareholders of an S corporation.
March 15, 2010, is paid or reimbursed from
X’s health FSA for the plan year ending plan year (or grace period) during which (iv) Examples. The following
December 31, 2010. As of March 16, 2010, X a participant can submit a claim for examples illustrate the rules in
has $1,400 remaining in the health FSA for reimbursement for a qualified benefit paragraphs (g)(2)(ii) and (g)(2)(iii) of this
the plan year ending December 31, 2010. incurred during the plan year (or grace section:
Example 2. Unused benefits exceed period). Thus, a plan is also permitted Example 1. Two-percent shareholders of an
expenses incurred during grace period. Same to provide a deadline on or after the end S corporation. (i) Employer K, an S
facts as Example 1, except that X incurs $150 of the plan year (or grace period) for corporation, maintains a cafeteria plan for its
of section 213(d) medical expenses during
submitting a claim for reimbursement employees (other than 2-percent shareholders
the grace period (January 1 through March of an S corporation). Employer K’s taxable
15, 2010). As of March 16, 2010, X has $50 for the plan year. Any run-out period
must be provided on a uniform and year and the plan year are the calendar year.
of unused benefits or contributions On January 1, 2009, individual Z owns 5
remaining for the plan year ending December consistent basis with respect to all
percent of the outstanding stock in Employer
31, 2009. The unused $50 cannot be cashed- participants. K. Y, who owns no stock in Employer K, is
out, converted to any other taxable or (g) Employee for purposes of section married to Z. Y and Z are employees of
nontaxable benefit, or used in any other plan 125—(1) Current employees, former Employer K. Z is a 2-percent shareholder in
year (including the plan year ending employees. The term employee includes Employer K (as defined in section 1372(b)).
December 31, 2009). The unused $50 is any current or former employee Y is also a 2-percent shareholder in Employer
subject to the use-or-lose rule in paragraph K by operation of the attribution rules in
(c) in § 1.125–5 and is forfeited. As of March (including any laid-off employee or
retired employee) of the employer. See section 318(a)(1)(A)(i).
16, 2010, X has the entire $1,500 elected in (ii) On July 15, 2009, Z sells all his stock
the health FSA for the plan year ending paragraph (g)(3) of this section
in Employer K to an unrelated third party,
December 31, 2010. concerning limits on participation by and ceases to be a 2-percent shareholder. Y
Example 3. Terminated participants. (i) former employees. Specifically, the term and Z continue to work as employees of
Employer J’s cafeteria plan includes a grace employee includes the following— Employer K during the entire 2009 calendar
period allowing all participants to apply (i) Common law employee; year. Y and Z are ineligible to participate in
unused benefits or contributions remaining at (ii) Leased employee described in Employer K’s cafeteria plan for the 2009 plan
the end of the plan year to qualified benefits
section 414(n); year.
incurred during the grace period immediately Example 2. Director and employee. T is an
following that plan year. For the plan year
(iii) Full-time life insurance salesman
(as defined in section 7701(a)(20)); and employee and also a director of Employer L,
ending on December 31, 2009, the grace a C corp that sponsors a cafeteria plan. The
period ends March 15, 2010. (iv) A current employee or former
employee described in paragraphs cafeteria plan allows only employees of
(ii) Employees A, B, C, and D each timely Employer L to participate in the cafeteria
elected $1,200 salary reduction for a health (g)(1)(i) through (iii) of this section. plan. T’s annual compensation as an
FSA for the plan year ending December 31, (2) Self-employed individual not an employee is $50,000; T is also paid $3,000
2009. Employees A and B terminated employee—(i) In general. The term annually in director’s fees. T makes a timely
employment on September 15, 2009. Each employee does not include a self- election to salary reduce $5,000 from his
has $500 of unused benefits or contributions employed individual or a 2-percent employee compensation for dependent care
in the health FSA.
shareholder of an S corporation, as benefits. T makes no election with respect to
(iii) Employee A elected COBRA for the his compensation as a director. T may
health FSA. Employee A is a participant in defined in paragraph (g)(2)(ii) of this
subsection. For example, a sole participate in the cafeteria plan in his
the cafeteria plan as of December 31, 2009, capacity as an employee of Employer L.
the last day of the 2009 plan year. Employee proprietor, a partner in a partnership, or
A has $500 of unused benefits or a director solely serving on a (3) Limits on participation by former
contributions available during the grace corporation’s board of directors (and not employees. Although former employees
period for the 2009 plan year (ending March otherwise providing services to the are treated as employees, a cafeteria
15, 2010). corporation as an employee) is not an plan may not be established or
(iv) Employee B did not elect COBRA for maintained predominantly for the
employee for purposes of section 125,
the health FSA. Employee B is not a
and thus is not permitted to participate benefit of former employees of the
participant in the cafeteria plan as of
December 31, 2009. The grace period does in a cafeteria plan. However, a sole employer. Such a plan is not a cafeteria
not apply to Employee B. proprietor may sponsor a cafeteria plan plan.
(v) Employee C has $500 of unused covering the sole proprietor’s employees (4) No participation by the spouse or
benefits in his health FSA as of December 31, (but not the sole proprietor). Similarly, dependent of an employee—(i) Benefits
2009, and terminated employment on a partnership or S corporation may allowed to participant’s spouse or
January 15, 2010. Employee C is a participant sponsor a cafeteria plan covering dependents but not participation. The
in the cafeteria plan as of December 31, 2009 employees (but not a partner or 2- spouse or dependents of employees may
and has $500 of unused benefits or not be participants in a cafeteria plan
contributions available during the grace percent shareholder of an S
period ending March 15, 2010, even though corporation). unless they are also employees.
he terminated employment on January 15, (ii) Two percent shareholder of an S However, a cafeteria plan may provide
2010. corporation. A 2-percent shareholder of benefits to spouses and dependents of
(vi) Employee D continues to work for an S corporation has the meaning set participants. For example, although an
Employer H throughout 2009 and 2010, also forth in section 1372(b). employee’s spouse may benefit from the
has $500 of unused benefits or contributions (iii) Certain dual status individuals. If employee’s election of accident and
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in his health FSA as of December 31, 2009, an individual is an employee of an health insurance coverage or of coverage
but made no health FSA election for 2010. employer and also provides services to through a dependent care assistance
Employee D is a participant in the cafeteria
plan as of December 31, 2009 and has $500
that employer as an independent program, the spouse may not participate
of unused benefits or contributions available contractor or director (for example, an in a cafeteria plan (that is, the spouse
during the grace period ending March 15, individual is both a director and an may not be given the opportunity to
2010, even though he is not a participant in employee of a C corp), the individual is elect or purchase benefits offered by the
a health FSA for the 2010 plan year. eligible to participate in that employer’s plan).

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(ii) Certain elections after employee’s and health coverage for an employee term life insurance is offered through a
death. An employee’s spouse is not a and his or her spouse or dependents is cafeteria plan, the nondiscrimination
participant in a cafeteria plan merely excludible from the employee’s gross rules in section 79(d) must be satisfied
because the spouse has the right, upon income. The fair market value of in order to exclude the coverage from
the death of the employee, to elect coverage for any other individual, gross income.
among various settlement options or to provided with respect to the employee, (2) Section 125 nondiscrimination
elect among permissible distribution is includible in the employee’s gross rules. Qualified benefits are includible
options with respect to the deceased income. § 1.106–1; § 1.61–21(a)(4), and in the gross income of highly
employee’s benefits through a section § 1.61–21(b)(1). A cafeteria plan is compensated participants or key
401(k) plan, Health Savings Account, or permitted to allow employees to elect employees if the nondiscrimination
certain group-term life insurance offered accident and health coverage for an rules of section 125 are not satisfied. See
through the cafeteria plan. See individual who is not the spouse or § 1.125–7.
§ 54.4980B–2, Q & A 8 and § 54.4980B– dependent of the employee as a taxable (3) Taxable benefits. If a benefit that
4, Q & A–1 of this chapter on COBRA benefit. is includible in gross income when
rights of a participant’s spouse or (3) Example. The following example offered separately is offered through a
dependents. illustrates the rules of this paragraph cafeteria plan, the benefit continues to
(5) Employees of certain controlled (h): be includible in gross income.
groups. All employees who are treated (k) Group-term life insurance—(1) In
Example. Accident and health plan general. In addition to offering up to
as employed by a single employer under coverage for individuals who are not a $50,000 in group-term life insurance
section 414(b), (c), (m), or (o) are treated spouse or dependent of an employee. (i)
as employed by a single employer for Employee C participates in Employer M’s
coverage excludible under section 79(a),
purposes of section 125. Section cafeteria plan. Employee C timely elects a cafeteria plan may offer coverage in
125(g)(4); section 414(t). salary reduction for employer-provided excess of that amount. The cost of
(h) After-tax employee accident and health coverage for himself and coverage in excess of $50,000 in group-
contributions—(1) Certain after-tax for accident and health coverage for his term life insurance coverage provided
employee contributions treated as cash. former spouse. C’s former spouse is not C’s under a policy or policies carried
In addition to the cash benefits dependent. A former spouse is not a spouse directly or indirectly by one or more
described in paragraph (a)(2) of this as defined in section 152. employers (taking into account all
section, in general, a benefit is treated (ii) The fair market value of the coverage coverage provided both through a
for the former spouse is $1,000. Employee C cafeteria plan and outside a cafeteria
as cash for purposes of section 125 if the has $1,000 includible in gross income for the
benefit does not defer compensation accident and health coverage of his former
plan) is includible in an employee’s
(except as provided in paragraph (o) of spouse, because the section 106 exclusion gross income. Group-term life insurance
this section) and an employee who applies only to employer-provided accident combined with permanent benefits,
receives the benefit purchases such and health coverage for the employee or the within the meaning of § 1.79–0, is a
benefit with after-tax employee employee’s spouse or dependents. prohibited benefit in a cafeteria plan.
contributions or is treated, for all (iii) No payments or reimbursements (2) Determining cost of insurance
purposes under the Code (including, for received under the accident and health includible in employee’s gross income—
example, reporting and withholding coverage result in gross income to Employee (i) In general. If the aggregate group-term
purposes), as receiving, at the time that C or to the former spouse. The result is the life insurance coverage on the life of the
same if the $1,000 for coverage of C’s former employee (under policies carried
the benefit is received, cash spouse is paid from C’s after-tax income
compensation equal to the full value of outside the cafeteria plan.
directly or indirectly by the employer)
the benefit at that time and then exceeds $50,000, all or a portion of the
purchasing the benefit with after-tax (i) Prohibited taxable benefits. Any insurance is provided through a
employee contributions. Thus, for taxable benefit not described in cafeteria plan, and the group-term life
example, long-term disability coverage paragraph (a)(2) of this section and not insurance is provided through a plan
is treated as cash for purposes of section treated as cash for purposes of section that meets the nondiscrimination rules
125 if the cafeteria plan provides that an 125 in paragraph (h) of this section is of section 79(d), the amount includible
employee may purchase the coverage not permitted to be included in a in an employee’s gross income is
through the cafeteria plan with after-tax cafeteria plan. A plan that offers taxable determined under paragraphs
employee contributions or provides that benefits other than the taxable benefits (k)(2)(i)(A) through (C) of this section.
the employee receiving such coverage is described in paragraph (a)(2) and (h) of For each employee—
treated as having received cash this section is not a cafeteria plan. (A) The entire amount of salary
compensation equal to the value of the (j) Coordination with other rules—(1) reduction and employer flex-credits
coverage and then as having purchased In general. If a benefit is excludible from through a cafeteria plan for group-term
the coverage with after-tax employee an employee’s gross income when life insurance coverage on the life of the
contributions. Also, for example, a provided separately, the benefit is employee is excludible from the
cafeteria plan may offer employees the excludible from gross income when employee’s gross income, regardless of
opportunity to purchase, with after-tax provided through a cafeteria plan. Thus, the amount of employer-provided
employee contributions, group-term life a qualified benefit is excludible from group-term life insurance on the
insurance on the life of an employee gross income if both the rules under employee’s life (that is, whether or not
(providing no permanent benefits), an section 125 and the specific rules the coverage provided to the employee
accident and health plan, or a providing for the exclusion of the both through the cafeteria plan and
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dependent care assistance program. benefit from gross income are satisfied. outside the cafeteria plan exceeds
(2) Accident and health coverage For example, if the nondiscrimination $50,000);
purchased for someone other than the rules for specific qualified benefits (for (B) The cost of the group-term life
employee’s spouse or dependents with example, sections 79(d), 105(h), insurance in excess of $50,000 of
after-tax employee contributions. If the 129(d)(2), 137(c)(2)) are not satisfied, coverage is includible in the employee’s
requirements of section 106 are those qualified benefits are includible in gross income. The amount includible in
satisfied, employer-provided accident gross income. Thus, if $50,000 in group- the employee’s income is determined

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43952 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

using the rules of § 1.79–3 and Table I in excess of the dollar limitation of section premiums for an employer-provided
(Uniform Premiums for $1,000 of Group- 79 is $100,000 (150,000–50,000). group health plan are qualified benefits
Term Life Insurance Protection). See (iv) The Table I cost is $120 for $100,000 if:
of group-term life insurance for an individual
subparagraph (C) of this paragraph (i) The premiums are excludible from
between ages 40 to 44, under (k)(2)(i)(B). The
(k)(2)(i) for determining the amount Table I cost of $120 is reduced by $100 an employee’s income under section
paid by the employee for purposes of (because B paid $100 for the group-term life 106; or
reducing the Table I amount includible insurance with after-tax employee (ii) The premiums are for the accident
in income under § 1.79–3. contributions), under paragraphs (k)(2)(i)(B) and health plan of the employer
(C) In determining the amount paid by and (k)(2)(i)(C) of this section. sponsoring the cafeteria plan, even if the
the employee toward the purchase of (v) The amount includible in B’s gross fair market value of the premiums is
the group-term life insurance for income for the $100,000 of excess group-term includible in an employee’s gross
life insurance coverage is $20.
purposes of § 1.79–3, only an income. See also paragraph (e)(2) in
Example 3. Excess group-term life
employee’s after-tax contributions are insurance coverage provided through salary § 1.125–5 and § 54.4980B–2, Q & A–8 of
treated as an amount paid by the reduction in a cafeteria plan and outside a this chapter for COBRA rules for health
employee. cafeteria plan. (i) Same facts as Example 1 FSAs.
(ii) Examples. The rules in this except that Employer N also provides (at no (2) Example. The following example
paragraph (k) are illustrated by the cost to employees) group-term life insurance illustrates the rules of this paragraph (l):
following examples, in which the group- coverage equal to each employee’s annual
Example. COBRA premiums. (i) Employer
term life insurance coverage satisfies the salary. Employee B’s annual salary is
O maintains a cafeteria plan for full-time
nondiscrimination rules in section $150,000. B has $150,000 of group-term life
employees, offering an election between cash
insurance directly from Employer N, and also
79(d), provides no permanent benefits, $150,000 coverage through Employer N’s
and employer-provided accident and health
is for a 12-month period, is the only insurance and other qualified benefits.
cafeteria plan.
group-term life insurance coverage (ii) B’s $200 of salary reduction for group- Employees A, B, and C participate in the
provided under a policy carried directly term life insurance is excludible from B’s cafeteria plan. On July 1, 2009, Employee A
or indirectly by the employer, and gross income, under paragraph (k)(2)(i)(A) of has a qualifying event (as defined in
this section. § 54.4980B–4 of this chapter).
applies Table I (Uniform Premiums for (ii) Employee A was a full-time employee
$1,000 of Group-Term Life Insurance (iii) B has a total of $300,000 of group-term
life insurance. The group-term life insurance and became a part-time employee and for
Protection) effective July 1, 1999: that reason, is no longer covered by Employer
in excess of the dollar limitation of section
Example 1. Excess group-term life 79 is $250,000 (300,000–50,000). O’s accident and health plan. Under § 1.125–
insurance coverage provided through salary (iv) The Table I cost is $300 for $250,000 4(f)(3)(ii), Employee A changes her election
reduction in a cafeteria plan. (i) Employer N of group-term life insurance for an individual to salary reduce to pay her COBRA
provides group-term life insurance coverage between ages 40 to 44. The Table I cost of premiums.
to its employees only through its cafeteria $300 is reduced by zero (because B paid no (iii) Employee B previously worked for
plan. Employer N’s cafeteria plan allows portion of the group-term life insurance with another employer, quit and elected COBRA.
employees to elect salary reduction for after-tax employee contributions), under Employee B begins work for Employer O on
group-term life insurance. Employee B, age paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this July 1, 2009, and becomes eligible to
42, elected salary reduction of $200 for section. participate in Employer O’s cafeteria plan on
$150,000 of group-term life insurance. None (v) The amount includible in B’s gross July 1, 2009, but will not be eligible to
of the group-term life insurance is paid income for the $250,000 of excess group-term participate in Employer O’s accident and
through after-tax employee contributions. life insurance is $300. health plan until October 1, 2009. Employee
(ii) B’s $200 of salary reduction for group- Example 4. Excess group-term life B elects to salary reduce to pay COBRA
term life insurance is excludible from B’s insurance coverage provided through salary premiums for coverage under the accident
gross income under paragraph (k)(2)(i)(A). reduction in a cafeteria plan and outside a and health plan sponsored by B’s former
(iii) B has a total of $150,000 of group-term cafeteria plan. (i) Same facts as Example 3 employer.
life insurance. The group-term life insurance except that Employee C’s annual salary is (iv) Employee C and C’s spouse are covered
in excess of the dollar limitation of section $30,000. C has $30,000 of group-term life by Employer O’s accident and health plan
79 is $100,000 (150,000–50,000). insurance coverage provided directly from until July 1, 2009, when C’s divorce from her
(iv) The Table I cost is $120 for $100,000 Employer N, and elects an additional $30,000 spouse became final. C continues to be
of group-term life insurance for an individual of coverage for $40 through Employer N’s covered by the accident and health plan. On
between ages 40 to 44. The Table I cost of cafeteria plan. C is 42 years old. July 1, 2009, C requests to pay COBRA
$120 is reduced by zero (because B paid no (ii) C’s $40 of salary reduction for group- premiums for her former spouse (who is not
portion of the group-term life insurance with term life insurance is excludible from C’s C’s dependent (as defined in section 152))
after-tax employee contributions), under gross income, under paragraph (k)(2)(i)(A) of with after-tax employee contributions.
paragraphs (k)(2)(i)(A)–(B) of this section. this section. (v) Salary reduction elections for COBRA
(v) The amount includible in B’s gross (iii) C has a total of $60,000 of group-term premiums for Employees A and B are
income for the $100,000 of excess group-term life insurance. The group-term life insurance qualified benefits for purposes of section 125
life insurance is $120. in excess of the dollar limitation of section and are excludible from the gross income of
Example 2. Excess group-term life 79 is $10,000 (60,000–50,000). Employees A and B. Employer O allows A
insurance coverage provided through salary (iv) The Table I cost is $12 for $10,000 of and B to salary reduce for these COBRA
reduction in a cafeteria plan where employee group-term life insurance for an individual premiums.
purchases a portion of group-term life between ages 40 to 44. The Table I cost of (vi) Employer O allows C to pay for
insurance coverage with after-tax $12 is reduced by zero (because C paid no COBRA premiums for C’s former spouse,
contributions. (i) Same facts as Example 1, portion of the group-term life insurance with with after-tax employee contributions
except that B elected salary reduction of $100 after-tax employee contributions), under because although accident and health
and makes an after-tax contribution of $100 paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this coverage for C’s former spouse is permitted
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toward the purchase of group-term life section. in a cafeteria plan, the premiums are
insurance coverage. (v) The amount includible in C’s gross includible in C’s gross income.
(ii) B’s $100 of salary reduction for group- income for the $10,000 of excess group-term (vii) The operation of Employer O’s
term life insurance is excludible from B’s life insurance coverage is $12. cafeteria plan satisfies the requirements of
gross income, under paragraph (k)(2)(i)(A) of this paragraph (l).
this section. (l) COBRA premiums—(1) Paying
(iii) B has a total of $150,000 of group-term COBRA premiums through a cafeteria (m) Payment or reimbursement of
life insurance. The group-term life insurance plan. Under § 1.125–4(c)(3)(iv), COBRA employees’ individual accident and

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43953

health insurance premiums—(1) In unused elective contributions, after-tax (iii) Additional permitted deferred
general. The payment or reimbursement contributions, or plan benefits from one compensation arrangements. A plan
of employees’ substantiated individual plan year to another (except as provided maintained by an educational
health insurance premiums is in paragraphs (e), (o)(3) and (4) and (p) organization described in section
excludible from employees’ gross of this section) defers compensation. 170(b)(1)(A)(ii) to the extent of amounts
income under section 106 and is a This is the case regardless of how the which a covered employee may elect to
qualified benefit for purposes of section contributions or benefits are used by the have the employer pay as contributions
125. employee in the subsequent plan year for post-retirement group life insurance
(2) Example. The following example (for example, whether they are is permitted through a cafeteria plan,
illustrates the rule of this paragraph (m): automatically or electively converted if—
Example. Payment or reimbursement of into another taxable or nontaxable (A) All contributions for such
premiums. (i) Employer P’s cafeteria plan benefit in the subsequent plan year or insurance must be made before
offers the following benefits for employees used to provide additional benefits of retirement; and
who are covered by an individual health the same type). Similarly, a cafeteria (B) Such life insurance does not have
insurance policy. The employee substantiates plan also defers compensation if the a cash surrender value at any time.
the expenses for the premiums for the policy plan permits employees to use
(as required in paragraph (b)(2) in § 1.125–6)
(iv) Contributions to HSAs.
contributions for one plan year to Contributions to covered employees’
before any payments or reimbursements to purchase a benefit that will be provided
the employee for premiums are made. The HSAs as defined in section 223 (but not
payments or reimbursements are made in the
in a subsequent plan year (for example, contributions to Archer MSAs).
following ways: life, health or disability if these benefits (4) Paid time off—(i) In general. A
(ii) The cafeteria plan reimburses each have a savings or investment feature, cafeteria plan is permitted to include
employee directly for the amount of the such as whole life insurance). See also elective paid time off (that is, vacation
employee’s substantiated health insurance Q & A–5 in § 1.125–3, prohibiting days, sick days or personal days) as a
premium; deferring compensation from one
(iii) The cafeteria plan issues the employee
permitted taxable benefit through the
cafeteria plan year to a subsequent plan by permitting employees to receive
a check payable to the health insurance cafeteria plan year. See paragraph (e) of
company for the amount of the employee’s more paid time off than the employer
this section for grace period rules. A otherwise provides to the employees on
health insurance premium, which the
employee is obligated to tender to the plan does not defer compensation a nonelective basis, but only if the
insurance company; merely because it allocates experience inclusion of elective paid time off
(iv) The cafeteria plan issues a check in the gains (or forfeitures) among participants through the plan does not operate to
same manner as (iii), except that the check in compliance with paragraph (o) in permit the deferral of compensation. In
is payable jointly to the employee and the § 1.125–5. addition, a plan that only offers the
insurance company; or (2) Effect if a plan includes a benefit
(v) Under these circumstances, the choice of cash or paid time off is not a
that defers the receipt of compensation
individual health insurance policies are cafeteria plan and is not subject to the
or a plan operates to defer
accident and health plans as defined in compensation. If a plan violates rules of section 125. In order to avoid
§ 1.106–1. This benefit is a qualified benefit
paragraph (o)(1) of this section, the deferral of compensation, the cafeteria
under section 125. plan must preclude any employee from
availability of an election between
(n) Section 105 rules for accident and taxable and nontaxable benefits under using the paid time off or receiving
health plan offered through a cafeteria such a plan results in gross income to cash, in a subsequent plan year, for any
plan—(1) General rule. In order for an the employees. portion of such paid time off remaining
accident and health plan to be a (3) Cash or deferred arrangements unused as of the end of the plan year.
qualified benefit that is excludible from that may be offered in a cafeteria plan. (See paragraph (o)(4)(iii) of this section
gross income if elected through a (i) In general. A cafeteria plan may offer for the deadline to cash out unused
cafeteria plan, the cafeteria plan must the benefits set forth in this paragraph elective paid time off.) For example, a
satisfy section 125 and the accident and (o)(3), even though these benefits defer plan that offers employees the
health plan must satisfy section 105(b) compensation. opportunity to purchase paid time off
and (h). (ii) Elective contributions to a section (or to receive cash or other benefits
(2) Section 105(b) requirements in 401(k) plan. A cafeteria plan may permit through the plan in lieu of paid time off)
general. Section 105(b) provides an a covered employee to elect to have the is not a cafeteria plan if employees who
exclusion from gross income for employer, on behalf of the employee, purchase the paid time off for a plan
amounts paid to an employee from an pay amounts as contributions to a trust year are allowed to use any unused paid
employer-funded accident and health that is part of a profit-sharing or stock time off in a subsequent plan year. This
plan specifically to reimburse the bonus plan or rural cooperative plan is the case even though the plan does
employee for certain expenses for (within the meaning of section not permit the employee to convert, in
medical care (as defined in section 401(k)(7)), which includes a qualified any subsequent plan year, the unused
213(d)) incurred by the employee or the cash or deferred arrangement (as paid time off into any other benefit.
employee’s spouse or dependents defined in section 401(k)(2)). In (ii) Ordering of elective and
during the period for which the benefit addition, after-tax employee nonelective paid time off. In
is provided to the employee (that is, contributions under a qualified plan determining whether a plan providing
when the employee is covered by the subject to section 401(m) are permitted paid time off operates to permit the
accident and health plan). through a cafeteria plan. The right to deferral of compensation, a cafeteria
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(o) Prohibition against deferred make such contributions does not cause plan must provide that employees are
compensation—(1) In general. Any plan a plan to fail to be a cafeteria plan deemed to use paid time off in the
that offers a benefit that defers merely because, under the qualified following order:
compensation (except as provided in plan, employer matching contributions (A) Nonelective paid time off.
this paragraph (o)) is not a cafeteria (as defined in section 401(m)(4)(A)) are Nonelective paid time off (that is, paid
plan. See section 125(d)(2)(A). A plan made with respect to elective or after- time off with respect to which the
that permits employees to carry over tax employee contributions. employee has no election) is used first;

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43954 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

(B) Elective paid time off. Elective uses only one week of paid time off during (B) Reasonable lifetime maximum
paid time off is used after all the year. Pursuant to the cafeteria plan, limit on benefits;
nonelective paid time off is used. Employee A is deemed to have used one (C) Level premiums;
nonelective week, and having retained one (D) Premium waiver during disability;
(iii) Cashing out or forfeiture of nonelective week and one elective week of
unused elective paid time off, in (E) Guaranteed policy renewability of
paid time off. Employee A receives in cash
general. The cafeteria plan must provide the value of the unused elective paid time off coverage, without further evidence of
that all unused elective paid time off on December 31, 2009. Employer Q includes insurability (but not guaranty of the
(determined as of the last day of the this amount on the 2009 Form W–2 for amount of premium upon renewal);
plan year) must either be paid in cash Employee A. Employee A must report this (F) Coverage for a specified accidental
(within the time specified in this amount as gross income in 2009. injury;
(ii) Pursuant to Employer Q’s human (G) Coverage for a specified disease or
paragraph (o)(4)) or be forfeited. This
resources policy, Employee A is permitted to illness, including payments at initial
provision must apply uniformly to all carry over the one nonelective week of paid
participants in the cafeteria plan. diagnosis of the specified disease or
time off to the next year. Nonelective paid
(A) Cash out of unused elective paid time off is not part of the cafeteria plan (that
illness, and progressive payments of a
time off. A plan does not operate to is, neither Employer Q nor the cafeteria plan set amount per month following the
permit the deferral of compensation permit employees to exchange nonelective initial diagnosis (sometimes referred to
merely because the plan provides that paid time off for other benefits). as progressive diagnosis payments); and
an employee who has not used all (iii) The cafeteria plan’s terms and (H) Payment of a fixed amount per
operations do not violate the prohibition day (or other period) of hospitalization.
elective paid time off for a plan year against deferring compensation.
receives in cash the value of such (ii) Requirements of permitted
Example 3. Forfeiture of unused elective benefits. All benefits described in
unused paid time off. The employee paid time off. Same facts as Example 2,
must receive the cash on or before the except that pursuant to the cafeteria plan,
paragraph (p)(1)(i) of this section must
last day of the cafeteria plan’s plan year Employee A forfeits the remaining one week in addition satisfy all of the following
to which the elective contributions used of elective paid time off. The cafeteria plan’s requirements—
terms and operations do not violate the (A) No part of any benefit is used in
to purchase the unused elective paid
prohibition against deferring compensation. one plan year to purchase a benefit in
time off relate. Example 4. Unused elective paid time off a subsequent plan year;
(B) Forfeiture of unused elective paid carried over to next plan year. Same facts as (B) The policies remain in force only
time off. If the cafeteria plan provides Example 1, except that Employee A uses only so long as premiums are timely paid on
for forfeiture of unused elective paid two weeks of paid time off during the 2009 a current basis, and, irrespective of the
time off, the forfeiture must be effective plan year, and, under the terms of the
cafeteria plan, Employee A is treated as amount of premiums paid in prior plan
on the last day of the plan year to which
having used the two nonelective weeks and years, if the current premiums are not
the elective contributions relate.
as having retained the one elective week. The paid, all coverage for new diseases or
(iv) No grace period for paid time off.
one remaining week (that is, the elective illnesses lapses. See paragraph
The grace period described in paragraph week) is carried over to the next plan year (p)(1)(i)(D), allowing premium waiver
(e) of this section does not apply to paid (or the value thereof used for any other during disability;
time off. purpose in the next plan year). The plan (C) There is no investment fund or
(v) Examples. The following examples operates to permit deferring compensation cash value to rely upon for payment of
illustrate the rules of this paragraph and is not a cafeteria plan.
Example 5. Paid time off exchanged for
premiums; and
(o)(4): (D) No part of any premium is held in
accident and health insurance premiums.
Example 1. Plan cashes out unused Employer R provides employees with four a separate account for any participant or
elective paid time off on or before the last weeks of paid time off for a year. Employer beneficiary, or otherwise segregated
day of the plan year. (i) Employer Q provides R’s calendar year cafeteria plan permits from the assets of the insurance
employees with two weeks of paid time off employees to exchange up to one week of company.
for each calendar year. Employer Q’s human paid time off to pay the employee’s share of (2) Benefits under a long-term
resources policy (that is, outside the cafeteria accident and health insurance premiums. For
plan), permits employees to carry over one
disability policy relating to more than
the 2009 plan year, Employee B (with a one year. A long-term disability policy
nonelective week of paid time off to the next calendar tax year), timely elects to exchange
year. Employer Q maintains a calendar year one week of paid time off (valued at $769)
paying disability benefits over more
cafeteria plan that permits the employee to to pay accident and health insurance than one year does not violate the
purchase, with elective contributions, an premiums for 2009. The $769 is excludible prohibition against deferring
additional week of paid time off. from Employee B’s gross income under compensation.
(ii) For the 2009 plan year, Employee A section 106. The cafeteria plan’s terms and (3) Reasonable premium rebates or
(with a calendar tax year), timely elects to operations do not violate the prohibition policy dividends. Reasonable premium
purchase one additional week of paid time against deferring compensation. rebates or policy dividends paid with
off. During 2009, Employee A uses only two
(p) Benefits relating to more than one respect to benefits provided through a
weeks of paid time off. Employee A is
deemed to have used two weeks of year—(1) Benefits in an accident and cafeteria plan do not constitute
nonelective paid time off and zero weeks of health insurance policy relating to more impermissible deferred compensation if
elective paid time off. than one year. Consistent with section such rebates or dividends are paid
(iii) Pursuant to the cafeteria plan, the plan 125(d), an accident and health before the close of the 12-month period
pays Employee A the value of the unused insurance policy may include certain immediately following the cafeteria plan
elective paid time off week in cash on benefits, as set forth in this paragraph year to which such rebates and
December 31, 2009. Employer Q includes this (p)(1), without violating the prohibition dividends relate.
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amount on the 2009 Form W–2 for Employee (4) Mandatory two-year election for
A. This amount is included in Employee A’s
against deferred compensation.
(i) Permitted benefits. The following vision or dental insurance. When a
gross income in 2009. The cafeteria plan’s
terms and operations do not violate the features or benefits of insurance policies cafeteria plan offers vision or dental
prohibition against deferring compensation. do not defer compensation— insurance that requires a mandatory
Example 2. Unused nonelective paid time (A) Credit toward the deductible for two-year coverage period, but not longer
off carried over to next plan year. (i) Same unreimbursed covered expenses (sometimes referred to as a ‘‘two-year
facts as Example 1, except that Employee A incurred in prior periods; lock-in’’), the mandatory two-year

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43955

coverage period does not result in (vii) Group-term life insurance on the to pay the employees’ share of any
deferred compensation in violation of life of any individual other than an qualified benefit through salary
section 125(d)(2), provided both of the employee (whether includible or reduction and not with after-tax
following requirements are satisfied— excludible from the employee’s gross employee contributions. A cafeteria
(i) The premiums for each plan year income); plan is also permitted to pay reasonable
are paid no less frequently than (viii) Health reimbursement cafeteria plan administrative fees
annually; and arrangements (HRAs) that provide through salary reduction amounts, and
(ii) In no event does a cafeteria plan reimbursements up to a maximum these salary reduction amounts are
use salary reduction or flex-credits dollar amount for a coverage period and excludible from an employee’s gross
relating to the first year of a two-year that all or any unused amount at the end income.
election to apply to vision or dental of a coverage period is carried forward (2) Salary reduction as employer
insurance for the second year of the to increase the maximum contribution. Salary reduction
two-year election. reimbursement amount in subsequent contributions are employer
(5) Using salary reduction amounts coverage periods; contributions. An employee’s salary
from one plan year to pay accident and (ix) Contributions to Archer MSAs reduction election is an election to
health insurance premiums for the first (section 220); and receive a contribution by the employer
month of the immediately following (x) Elective deferrals to a section in lieu of salary or other compensation
plan year. 403(b) plan. that is not currently available to the
(i) In general. Salary reduction (2) Nonqualified benefits not employee as of the effective date of the
amounts from the last month of one permitted in a cafeteria plan. The election and that does not subsequently
plan year of a cafeteria plan may be benefits described in this paragraph (q) become currently available to the
applied to pay accident and health are not qualified benefits or taxable employee.
insurance premiums for insurance benefits or cash for purposes of section (3) Employer flex-credits. A cafeteria
during the first month of the 125 and thus may not be offered in a plan may also provide that the employer
immediately following plan year, if cafeteria plan regardless of whether any contributions will or may be made on
done on a uniform and consistent basis such benefit is purchased with after-tax behalf of employees equal to (or up to)
with respect to all participants (based employee contributions or on any other specified amounts (or specified
on the usual payroll interval for each basis. A plan that offers a nonqualified percentages of compensation) and that
group of participants). benefit is not a cafeteria plan. such nonelective contributions are
(ii) Example. The following example Employees’ elections between taxable available to employees for the election
illustrates the rules in this paragraph and nontaxable benefits through such of benefits through the plan.
(p)(5): plan result in gross income to the (4) Elective contributions to a section
Example. Salary reduction payments in participants for any benefit elected. See 401(k) plan. See § 1.401(k)–1 for general
December of calendar plan year to pay section 125(f). See paragraph (q)(3) of rules relating to contributions to section
accident and health insurance premiums for this section for special rule on long-term 401(k) plans.
January. Employer S maintains a calendar care insurance purchased through an (s) Effective/applicability date. It is
year cafeteria plan. The cafeteria plan offers HSA. proposed that these regulations apply
employees a salary reduction election for (3) Long-term care insurance or on and after plan years beginning on or
accident and health insurance. The plan services purchased through an HSA.
provides that employees’ salary reduction after January 1, 2009, except that the
Although long-term care insurance is rule in paragraph (k)(2)(i)(B) of this
amounts for the last pay period in December
are applied to pay accident and health
not a qualified benefit and may not be section is effective as of the date the
insurance premiums for the immediately offered in a cafeteria plan, a cafeteria proposed regulations are published in
following January. All employees are paid bi- plan is permitted to offer an HSA as a the Federal Register.
weekly. For the plan year ending December qualified benefit, and funds from the
31, 2009, Employee C elects salary reduction HSA may be used to pay eligible long- § 1.125–2 Cafeteria plans; elections.
of $3,250 for accident and health coverage. term care premiums on a qualified long- (a) Rules relating to making and
For the last pay period in December 2009, term care insurance contract or for revoking elections—(1) Elections in
$125 (3,250/26) is applied to the accident
and health insurance premium for January
qualified long-term care services. general. A plan is not a cafeteria plan
2010. This plan provision does not violate
(r) Employer contributions to a unless the plan provides in writing that
the prohibition against deferring cafeteria plan—(1) Salary reduction-in employees are permitted to make
compensation. general. The term employer elections among the permitted taxable
contributions means amounts that are benefits and qualified benefits offered
(q) Nonqualified benefits—(1) In
not currently available (after taking through the plan for the plan year (and
general. The following benefits are
section 125 into account) to the grace period, if applicable). All elections
nonqualified benefits that are not
employee but are specified in the must be irrevocable by the date
permitted to be offered in a cafeteria
cafeteria plan as amounts that an described in paragraph (a)(2) of this
plan—
(i) Scholarships described in section employee may use for the purpose of section except as provided in paragraph
117; electing benefits through the plan. A (a)(4) of this section. An election is not
(ii) Employer-provided meals and plan may provide that employer irrevocable if, after the earlier of the
lodging described in section 119; contributions may be made, in whole or dates specified in paragraph (a)(2) of
(iii) Educational assistance described in part, pursuant to employees’ this section, employees have the right to
in section 127; elections to reduce their compensation revoke their elections of qualified
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(iv) Fringe benefits described in or to forgo increases in compensation benefits and instead receive the taxable
section 132; and to have such amounts contributed, benefits for such period, without regard
(v) Long-term care insurance, or any as employer contributions, by the to whether the employees actually
product which is advertised, marketed employer on their behalf. See also revoke their elections.
or offered as long-term care insurance; § 1.125–5 (flexible spending (2) Timing of elections. In order for
(vi) Long-term care services (but see arrangements). Also, a cafeteria plan is employees to exclude qualified benefits
paragraph (q)(3) of this section); permitted to require employees to elect from employees’ gross income, benefit

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43956 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

elections in a cafeteria plan must be program of up to $5,000 of dependent care the beginning of each subsequent plan year,
made before the earlier of— expenses incurred by the employee during except that the notice for a current employee
(i) The date when taxable benefits are the plan year. The cafeteria plan requires includes a description of the employee’s
currently available; or employees to elect between these benefits existing coverage, if any.
(ii) The first day of the plan year (or before the beginning of the plan year. After (iv) For a new employee, an election to
the year has commenced, employees are receive cash or to have family coverage rather
other coverage period). prohibited from revoking their elections. The than employee-only coverage is effective if
(3) Benefit currently available to an cafeteria plan allows revocation of elections made when the employee is hired. For a
employee-in general. Cash or another based on changes in status (as described in current employee, an election is effective if
taxable benefit is currently available to § 1.125–4). Employees who elected the made prior to the start of each calendar year
the employee if it has been paid to the dependent care assistance program do not or under any other circumstances permitted
employee or if the employee is able include the $5,000 cash in gross income. The under § 1.125–4. An election made for any
currently to receive the cash or other cafeteria plan satisfies the requirements in prior year is deemed to be continued for
taxable benefit at the employee’s this paragraph (a). every succeeding plan year, unless changed.
discretion. However, cash or another Example 2. Election revocable during plan (v) Contributions used to purchase
taxable benefit is not currently available year. Same facts as Example 1 except that accident and health insurance through a
Employer A’s cafeteria plan allows cafeteria plan are not includible in the gross
to an employee if there is a significant employees to revoke their elections for income of the employee solely because the
limitation or restriction on the dependent care assistance at any time during plan provides for automatic enrollment as a
employee’s right to receive the benefit the plan year and receive the unused amount default election whereby the employee’s
currently. Similarly, a benefit is not of dependent care assistance as cash. The salary is reduced each year to pay for a
currently available as of a date if the cafeteria plan fails to satisfy the requirements portion of the accident and health insurance
employee may under no circumstances in this paragraph (a), and is not a cafeteria through the plan (unless the employee
receive the benefit before a particular plan. All employees are treated as having affirmatively elects cash).
time in the future. The determination of received the $5,000 in cash even if they do
not revoke their elections. The same result
(c) Election rules for salary reduction
whether a benefit is currently available occurs even though the cash is not payable contributions to HSAs—(1) Prospective
to an employee does not depend on until the end of the plan year. elections and changes in salary
whether it has been constructively reduction elections allowed.
received by the employee for purposes (b) Automatic elections—(1) In
Contributions may be made to an HSA
of section 451. general. For new employees or current
through a cafeteria plan. A cafeteria
(4) Exceptions to rule on making and employees who fail to timely elect
plan offering HSA contributions through
revoking elections. If a cafeteria plan between permitted taxable benefits and
salary reduction may permit employees
incorporates the change in status rules qualified benefits, a cafeteria plan is
to make prospective salary reduction
in § 1.125–4, to the extent provided in permitted, but is not required, to
elections or change or revoke salary
those rules, an employee who provide default elections for one or
reduction elections for HSA
experiences a change in status (as more qualified benefits (for example, an
contributions (for example, to increase
defined in § 1.125–4) is permitted to election made for any prior year is
or decrease salary reduction elections
revoke an existing election and to make deemed to be continued for every
for HSA contributions) at any time
a new election with respect to the succeeding plan year, unless changed).
during the plan year, effective before
remaining portion of the period of (2) Example. The following example
salary becomes currently available. If a
coverage, but only with respect to cash illustrates the rules in this paragraph
cafeteria plan offers HSA contributions
or other taxable benefits that are not yet (b):
as a qualified benefit, the plan must—
currently available. See paragraph (c)(1) Example. Automatic elections for accident (i) Specifically describe the HSA
of this section for a special rule for and health insurance. (i) Employer B contribution benefit;
changing elections prospectively for maintains a calendar year cafeteria plan. The (ii) Allow a participant to
cafeteria plan offers accident and health
HSA contributions and paragraph (r)(4) prospectively change his or her salary
insurance with an option for employee-only
in § 1.125–1 for section 401(k) elections. or family coverage. All employees are eligible reduction election for HSA
Also, only an employee of the employer to participate in the cafeteria plan contributions on a monthly basis (or
sponsoring a cafeteria plan is allowed to immediately upon hire. more frequently); and
make, revoke or change elections in the (ii) The cafeteria plan provides for an (iii) Allow a participant who becomes
employer’s cafeteria plan. The automatic enrollment process: Each new ineligible to make HSA contributions to
employee’s spouse, dependent or any employee and each current employee is prospectively revoke his or her salary
other individual other than the automatically enrolled in employee-only reduction election for HSA
coverage under the accident and health contributions.
employee may not make, revoke or
insurance plan, and the employee’s salary is (2) Example. The following example
change elections under the plan. reduced to pay the employee’s share of the
(5) Elections not required on written accident and health insurance premium,
illustrates the rules in this paragraph (c):
paper documents. A cafeteria plan does unless the employee affirmatively elects Example. Prospective HSA salary
not fail to meet the requirements of cash. Alternatively, if the employee has a reduction elections. (i) A cafeteria plan with
section 125 merely because it permits spouse or child, the employee can elect a calendar plan year allows employees to
employees to use electronic media for family coverage. make salary reduction elections for HSA
such transactions. The safe harbor in (iii) When an employee is hired, the contributions through the plan. The cafeteria
§ 1.401(a)–21 applies to electronic employee receives a notice explaining the plan permits employees to prospectively
elections, revocations and changes in automatic enrollment process and the make, change or revoke salary contribution
employee’s right to decline coverage and elections for HSA contributions, limited to
elections under section 125.
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have no salary reduction. The notice includes one election, change or revocation per
(6) Examples. The following examples the salary reduction amounts for employee- month.
illustrate the rules in this paragraph (a): only coverage and family coverage, (ii) Employee M participates in the
Example 1. Election not revocable during procedures for exercising the right to decline cafeteria plan. Before salary becomes
plan year. Employer A’s cafeteria plan offers coverage, information on the time by which currently available to M, M makes the
each employee the opportunity to elect, for an election must be made, and the period for following elections. On January 2, 2009, M
a plan year, between $5,000 cash for the plan which an election is effective. The notice is elects to contribute $100 for each pay period
year and a dependent care assistance also given to each current employee before to an HSA, effective January 3, 2009. On

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March 15, 2009, M elects to reduce the HSA maximum amounts of reimbursement. (d) Uniform coverage rules applicable
contribution to $35 per pay period, effective See paragraph (r) in § 1.125–1 and to health FSAs—(1) Uniform coverage
April 1, 2009. On May 1, 2009, M elects to paragraphs (b) and (d) in this section for throughout coverage period—in general.
discontinue all HSA contributions, effective the definition of salary reduction, The maximum amount of
May 15, 2009. The cafeteria plan implements
all of Employee M’s elections,
employer flex-credit, and uniform reimbursement from a health FSA must
(iii) The cafeteria plan’s operation is coverage rule. be available at all times during the
consistent with the section 125 election, (b) Flex-credits allowed—(1) In period of coverage (properly reduced as
change and revocation rules for HSA general. An FSA in a cafeteria plan must of any particular time for prior
contributions. include an election between cash or reimbursements for the same period of
taxable benefits (including salary coverage). Thus, the maximum amount
(d) Optional election for new
reduction) and one or more qualified of reimbursement at any particular time
employees. A cafeteria plan may
benefits, and may include, in addition, during the period of coverage cannot
provide new employees 30 days after
‘‘employer flex-credits.’’ For this relate to the amount that has been
their hire date to make elections
purpose, flex-credits are non-elective contributed to the FSA at any particular
between cash and qualified benefits.
employer contributions that the time prior to the end of the plan year.
The election is effective as of the
employer makes for every employee Similarly, the payment schedule for the
employee’s hire date. However, salary
eligible to participate in the employer’s required amount for coverage under a
reduction amounts used to pay for such
cafeteria plan, to be used at the health FSA may not be based on the rate
an election must be from compensation
employee’s election only for one or or amount of covered claims incurred
not yet currently available on the date
more qualified benefits (but not as cash during the coverage period. Employees’
of the election. The written cafeteria
or a taxable benefit). See § 1.125–1 for salary reduction payments must not be
plan must provide that any employee
definitions of qualified benefits, cash accelerated based on employees’
who terminates employment and is
and taxable benefits. incurred claims and reimbursements.
rehired within 30 days after terminating (2) Example. The following example (2) Reimbursement available at all
employment (or who returns to illustrates the rules in this paragraph times. Reimbursement is deemed to be
employment following an unpaid leave (b): available at all times if it is paid at least
of absence of less than 30 days) is not
Example. Flex-credit. Contribution to monthly or when the total amount of the
a new employee eligible for the election
health FSA for employees electing employer- claims to be submitted is at least a
in this paragraph (d).
provided accident and health plan. Employer specified, reasonable minimum amount
(e) Effective/applicability date. It is A maintains a cafeteria plan offering (for example, $50).
proposed that these regulations apply employees an election between cash or (3) Terminated participants. When an
on and after plan years beginning on or taxable benefits and premiums for employer- employee ceases to be a participant, the
after January 1, 2009. provided accident and health insurance or
cafeteria plan must pay the former
Par. 3. Sections 1.125–5, 1.125–6 and coverage through an HMO. The plan also
provides an employer contribution of $200 to participant any amount the former
1.125–7 are added to read as follows: participant previously paid for coverage
the health FSA of every employee who elects
§ 1.125–5 Flexible spending arrangements. accident and health insurance or HMO or benefits to the extent the previously
(a) Definition of flexible spending coverage. In addition, these employees may paid amount relates to the period from
elect to reduce their salary to make the date the employee ceases to be a
arrangement—(1) In general. An FSA additional contributions to their health FSAs.
generally is a benefit program that participant through the end of that plan
The benefits offered in this cafeteria plan are year. See paragraph (e)(2) in this section
provides employees with coverage consistent with the requirements of section
which reimburses specified, incurred for COBRA elections for health FSAs.
125 and this paragraph (b).
expenses (subject to reimbursement (4) Example. The following example
(c) Use-or-lose rule—(1) In general. illustrates the rules in this paragraph
maximums and any other reasonable An FSA may not defer compensation.
conditions). An expense for qualified (d):
No contribution or benefit from an FSA Example. Uniform coverage. (i) Employer C
benefits must not be reimbursed from may be carried over to any subsequent
the FSA unless it is incurred during a maintains a calendar year cafeteria plan,
plan year or period of coverage. See offering an election between cash and a
period of coverage. See paragraph (e) of paragraph (k)(3) in this section for health FSA. The cafeteria plan prohibits
this section. After an expense for a specific exceptions. Unused benefits or accelerating employees’ salary reduction
qualified benefit has been incurred, the contributions remaining at the end of payments based on employees’ incurred
expense must first be substantiated the plan year (or at the end of a grace claims and reimbursements.
before the expense is reimbursed. See period, if applicable) are forfeited. (ii) For the 2009 plan year, Employee N
paragraphs (a) through (f) in § 1.125–6. (2) Example. The following example timely elects salary reduction of $3,000 for a
(2) Maximum amount of health FSA. Employee N pays the $3,000
illustrates the rules in this paragraph (c): salary reduction amount through salary
reimbursement. The maximum amount
of reimbursement that is reasonably Example. Use-or-lose rule. (i) Employer B reduction of $250 per month throughout the
maintains a calendar year cafeteria plan, coverage period. Employee N is eligible to
available to an employee for a period of offering an election between cash and a receive the maximum amount of
coverage must not be substantially in health FSA. The cafeteria plan has no grace reimbursement of $3,000 at all times
excess of the total salary reduction and period. throughout the coverage period (reduced by
employer flex-credit for such (ii) Employee A plans to have eye surgery prior reimbursements).
participant’s coverage. A maximum in 2009. For the 2009 plan year, Employee A (iii) N incurs $2,500 of section 213(d)
amount of reimbursement is not timely elects salary reduction of $3,000 for a medical expenses in January, 2009. The full
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substantially in excess of the total salary health FSA. During the 2009 plan year, $2,500 is reimbursed although Employee N
reduction and employer flex-credit if Employee A learns that she cannot have eye has made only one salary reduction payment
surgery performed, but incurs other section of $250. N incurs $500 in medical expenses
such maximum amount is less than 500 213(d) medical expenses totaling $1,200. As in February, 2009. The remaining $500 of the
percent of the combined salary of December 31, 2009, she has $1,800 of $3,000 is reimbursed. After Employee N
reduction and employer flex-credit. A unused benefits and contributions in the submits a claim for reimbursement and
single FSA may provide participants health FSA. Consistent with the rules in this substantiates the medical expenses, the
with different levels of coverage and paragraph (c), she forfeits $1,800. cafeteria plan reimburses N for the $2,500

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43958 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

and $500 medical expenses. Employer C’s of coverage on account of changes in purchased with contributions made at
cafeteria plan satisfies the uniform coverage family status. the employer’s discretion, at the
rule. (g) FSA administrative practices—(1) employee’s discretion, or pursuant to a
(5) No uniform coverage rule for FSAs Limiting health FSA enrollment to collective bargaining agreement.
for dependent care assistance or employees who participate in the Arrangements formally outside of the
adoption assistance. The uniform employer’s accident and health plan. At cafeteria plan providing for the
coverage rule applies only to health the employer’s option, a cafeteria plan adjustment of an employee’s
FSAs and does not apply to FSAs for is permitted to provide that only those compensation or an employee’s receipt
dependent care assistance or adoption employees who participate in one or of any other benefits on the basis of the
assistance. See paragraphs (i) and (j) of more specified employer-provided assistance or reimbursements received
this section for the rules for FSAs for accident and health plans may by the employee are considered in
dependent care assistance and adoption participate in a health FSA. See § 1.125– determining whether a dependent care
assistance. 7 for nondiscrimination rules. benefit is a dependent care assistance
(e) Required period of coverage for a (2) Interval for employees’ salary program under section 129.
health FSA, dependent care FSA and reduction contributions. The cafeteria (j) Section 137 rules for adoption
adoption assistance FSA—(1) Twelve- plan is permitted to specify any interval assistance program offered through a
month period of coverage—in general. for employees’ salary reduction cafeteria plan—(1) General rule. In
contributions. The interval specified in order for adoption assistance to be a
An FSA’s period of coverage must be 12
the plan must be uniform for all qualified benefit that is excludible from
months. However, in the case of a short
participants. gross income if elected through a
plan year, the period of coverage is the (h) Qualified benefits permitted to be
entire short plan year. See paragraph (d) cafeteria plan, the cafeteria plan must
offered through an FSA. Dependent care satisfy section 125 and the adoption
in § 1.125–1 for rules on plan years and assistance (section 129), adoption
changing plan years. assistance must satisfy section 137.
assistance (section 137) and a medical (2) Adoption assistance in general.
(2) COBRA elections for health FSAs. reimbursement arrangement (section Section 137(a) provides an employee
For the application of the health care 105(b)) are permitted to be offered with an exclusion from gross income for
continuation rules of section 4980B of through an FSA in a cafeteria plan. amounts paid or expenses incurred by
the Code to health FSAs, see Q & A–2 (i) Section 129 rules for dependent the employer for qualified adoption
in § 54.4980B–2 of this chapter. care assistance program offered through expenses in connection with an
(3) Separate period of coverage a cafeteria plan—(1) General rule. In employee’s adoption of a child, if the
permitted for each qualified benefit order for dependent care assistance to amounts are paid or incurred through an
offered through FSA. Dependent care be a qualified benefit that is excludible adoption assistance program. Certain
assistance, adoption assistance, and a from gross income if elected through a limits on amount of expenses and
health FSA are each permitted to have cafeteria plan, the cafeteria plan must employee’s income apply.
a separate period of coverage, which satisfy section 125 and the dependent (3) Reimbursement exclusively for
may be different from the plan year of care assistance must satisfy section 129. adoption assistance. Rules and
the cafeteria plan. (2) Dependent care assistance in requirements similar to the rules and
(f) Coverage on a month-by-month or general. Section 129(a) provides an requirements in paragraph (i)(3) of this
expense-by-expense basis prohibited. In employee with an exclusion from gross section for dependent care assistance
order for reimbursements from an income both for an employer-funded apply to adoption assistance.
accident and health plan to qualify for dependent care assistance program and (k) FSAs and the rules governing the
the section 105(b) exclusion, an for amounts paid or incurred by the tax-favored treatment of employer-
employer-funded accident and health employer for dependent care assistance provided health benefits—(1) Medical
plan offered through a cafeteria plan provided to the employee, if the expenses. Health plans that are flexible
may not operate in a manner that amounts are paid or incurred through a spending arrangements, as defined in
enables employees to purchase the dependent care assistance program. See paragraph (a)(1) of this section, must
accident and health plan coverage only paragraph (a)(4) in § 1.125–6 on when conform to the generally applicable
for periods when employees expect to dependent care expenses are incurred. rules under sections 105 and 106 in
incur medical care expenses. Thus, for (3) Reimbursement exclusively for order for the coverage and
example, if a cafeteria plan permits dependent care assistance. A dependent reimbursements under such plans to
employees to receive accident and care assistance program may not qualify for tax-favored treatment under
health plan coverage on a month-by- provide reimbursements other than for such sections. Thus, health FSAs must
month or an expense-by-expense basis, dependent care expenses; in particular, qualify as accident and health plans.
reimbursements from the accident and if an employee has dependent care See paragraph (n) in § 1.125–1. A health
health plan fail to qualify for the section expenses less than the amount specified FSA is only permitted to reimburse
105(b) exclusion. If, however, the period by salary reduction, the plan may not medical expenses as defined in section
of coverage under an accident and provide other taxable or nontaxable 213(d). Thus, for example, a health FSA
health plan offered through a cafeteria benefits for any portion of the specified is not permitted to reimburse dependent
plan is twelve months and the cafeteria amount not used for the reimbursement care expenses.
plan does not permit an employee to of dependent care expenses. Thus, if an (2) Limiting payment or
elect specific amounts of coverage, employee has elected coverage under reimbursement to certain section 213(d)
reimbursement, or salary reduction for the dependent care assistance program medical expenses. A health FSA is
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less than twelve months, the cafeteria and the period of coverage has permitted to limit payment or
plan does not operate to enable commenced, the employee must not reimbursement to only certain section
participants to purchase coverage only have the right to receive amounts from 213(d) medical expenses (except health
for periods during which medical care the program other than as insurance, long-term care services or
will be incurred. See § 1.125–4 and reimbursements for dependent care insurance). See paragraph (q) in § 1.125–
paragraph (a) in § 1.125–2 regarding the expenses. This is the case regardless of 1. For example, a health FSA in a
revocation of elections during a period whether coverage under the program is cafeteria plan is permitted to provide in

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the written plan that the plan insurance premiums or for long-term (4) Post-deductible health FSA—(i) In
reimburses all section 213(d) medical care services for the employee or general. A post-deductible health FSA is
expenses allowed to be paid or employee’s spouse or dependent. See a health FSA described in the cafeteria
reimbursed under a cafeteria plan paragraph (q) in § 1.125–1 for plan that only pays or reimburses
except over-the-counter drugs. nonqualified benefits medical expenses (as defined in section
(3) Application of prohibition against (l) Section 105(h) requirements. 213(d)) for preventive care or medical
deferred compensation to medical Section 105(h) applies to health FSAs. expenses incurred after the minimum
expenses—(i) Certain advance payments Section 105(h) provides that the annual HDHP deductible under section
for orthodontia permitted. A cafeteria exclusion provided by section 105(b) is 223(c)(2)(A)(i) is satisfied. See
plan is permitted, but is not required to, not available with respect to certain paragraph (k) in this section. No
reimburse employees for orthodontia amounts received by a highly medical expenses incurred before the
services before the services are provided compensated individual (as defined in annual HDHP deductible is satisfied
but only to the extent that the employee section 105(h)(5)) from a discriminatory may be reimbursed by a post-deductible
has actually made the payments in self-insured medical reimbursement FSA, regardless of whether the HDHP
advance of the orthodontia services in plan, which includes health FSAs. See covers the expense or whether the
order to receive the services. These § 1.105–11. For purposes of section deductible is later satisfied. For
orthodontia services are deemed to be 105(h), coverage by a self-insured example, even if chiropractic care is not
incurred when the employee makes the accident and health plan offered covered under the HDHP, expenses for
advance payment. Reimbursing advance through a cafeteria plan is an optional chiropractic care incurred before the
payments does not violate the benefit (even if only one level and type HDHP deductible is satisfied are not
prohibition against deferring of coverage is offered) and, for purposes reimbursable at any time by a post-
compensation. of the optional benefit rule in § 1.105– deductible health FSA.
(ii) Example. The following example 11(c)(3)(i), employer contributions are (ii) HDHP and health FSA
illustrates the rules in paragraph (k)(3): treated as employee contributions to the deductibles. The deductible for a post-
extent that taxable benefits are offered deductible health FSA need not be the
Example. Advance payment to
by the plan. same amount as the deductible for the
orthodontist. Employer D sponsors a calendar
year cafeteria plan which offers a health FSA. (m) HSA-compatible FSAs-limited- HDHP, but in no event may the post-
Employee K elects to salary reduce $3,000 for purpose health FSAs and post- deductible health FSA or other coverage
a health FSA for the 2009 plan year. provide benefits before the minimum
deductible health FSAs—(1) In general.
Employee K’s dependent requires annual HDHP deductible under section
Limited-purpose health FSAs and post-
orthodontic treatment. K’s accident and 223(c)(2)(A)(i) is satisfied (other than
health insurance does not cover orthodontia.
deductible health FSAs which satisfy all
benefits permitted under a limited-
The orthodontist, following the normal the requirements of section 125 are
purpose health FSA). In addition,
practice, charges $3,000, all due in 2009, for permitted to be offered through a
although the deductibles of the HDHP
treatment, to begin in 2009 and end in 2010. cafeteria plan.
and the other coverage may be satisfied
K pays the $3,000 in 2009. In 2009, Employer (2) HSA-compatible FSAs. Section independently by separate expenses, no
D’s cafeteria plan may reimburse $3,000 to K, 223(a) allows a deduction for certain
without violating the prohibition against benefits may be paid before the
contributions to a ‘‘Health Savings minimum annual deductible under
deferring compensation in section 125(d)(2). Account’’ (HSA) (as defined in section section 223(c)(2)(A)(i) has been
(iii) Reimbursements for durable 223(d)). An eligible individual (as satisfied. An individual covered by a
medical equipment. A health FSA in a defined in section 223(c)(1)) may post-deductible health FSA (if otherwise
cafeteria plan that reimburses contribute to an HSA. An eligible an eligible individual) is an eligible
employees for equipment (described in individual must be covered under a individual for the purpose of
section 213(d)) with a useful life ‘‘high deductible health plan’’ (HDHP) contributing to the HSA.
extending beyond the period of coverage and not, while covered under an HDHP, (5) Combination of limited-purpose
during which the expense is incurred under any health plan which is not an health FSA and post-deductible health
does not provide deferred HDHP. A general purpose health FSA is FSA. An FSA is a combination of a
compensation. For example, a health not an HDHP and an individual covered limited-purpose health FSA and post-
FSA is permitted to reimburse the cost by a general purpose health FSA is not deductible health FSA if each of the
of a wheelchair for an employee. eligible to contribute to an HSA. benefits and reimbursements provided
(4) No reimbursement of premiums for However, an individual covered by an under the FSA are permitted under
accident and health insurance or long- HDHP (and who otherwise satisfies either a limited-purpose health FSA or
term care insurance or services. A section 223(c)(1)) does not fail to be an post-deductible health FSA. For
health FSA is not permitted to treat eligible individual merely because the example, before the HDHP deductible is
employees’ premium payments for other individual is also covered by a limited- satisfied, a combination limited-purpose
health coverage as reimbursable purpose health FSA or post-deductible and post-deductible health FSA may
expenses. Thus, for example, a health health FSA (as defined in this paragraph reimburse only preventive, vision or
FSA is not permitted to reimburse (m)) or a combination of a limited- dental expenses. A combination limited-
employees for payments for other health purpose health FSA and a post- purpose and post-deductible health FSA
plan coverage, including premiums for deductible health FSA. may also reimburse any medical
COBRA coverage, accidental death and (3) Limited-purpose health FSA. A expense that may otherwise be paid by
dismemberment insurance, long-term limited-purpose health FSA is a health an FSA (that is, no insurance premiums
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disability or short-term disability FSA described in the cafeteria plan that or long-term care benefits) that is
insurance or for health coverage under only pays or reimburses permitted incurred after the HDHP deductible is
a plan maintained by the employer of coverage benefits (as defined in section satisfied.
the employee or the employer of the 223(c)(2)(C)), such as vision care, dental (6) Substantiation. The substantiation
employee’s spouse or dependent. Also, care or preventive care (as defined for rules in this section apply to limited-
a health FSA is not permitted to purposes of section 223(c)(2)(C)). See purpose health FSAs and to post-
reimburse expenses for long-term care paragraph (k) in this section. deductible health FSAs. In addition to

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43960 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

providing third-party substantiation of section 223(c)(1)) at any time during a employees based (directly or indirectly)
medical expenses, a participant in a testing period following the qualified on their individual claims experience.
post-deductible health FSA must HSA distribution, the amount of the Experience gains may not be used as
provide information from an distribution is includible in the contributions directly or indirectly to
independent third party that the HDHP participant’s gross income and he or she any deferred compensation benefit plan.
deductible has been satisfied. A is also subject to an additional 10 (3) Example. The following example
participant in a limited-purpose health percent tax (with certain exceptions). illustrates the rules in this paragraph
FSA must provide information from an Section 106(e)(3). (o):
independent third-party that the (3) No effect on health FSA elections, Example. Allocating experience gains. (i)
medical expenses are for vision care, coverage, use-or-lose rule. A qualified Employer L maintains a cafeteria plan for its
dental care or preventive care. HSA distribution does not alter an 1,200 employees, who may elect one of
(7) Plan amendments. See paragraph employee’s irrevocable election under several different annual coverage levels
(c) in § 1.125–1 on the required effective paragraph (a) of § 1.125–2, or constitute under a health FSA in $100 increments from
date for amendments adopting or a change in status under § 1.125–4(a). If $500 to $2,000.
a qualified HSA distribution is made to (ii) For the 2009 plan year, 1,000
changing limited-purpose, post- employees elect levels of coverage under the
deductible or combination limited- an employee’s HSA, even if the balance health FSA. For the 2009 plan year, the
purpose and post-deductible health in a health FSA is reduced to zero, the health FSA has an experience gain of $5,000.
FSAs. employee’s health FSA coverage (iii) The $5,000 may be allocated to all
(n) Qualified HSA distributions—(1) continues to the end of the plan year. participants for the plan year on a per capita
In general. A health FSA in a cafeteria Unused benefits and contributions basis weighted to reflect the participants’
plan is permitted to offer employees the remaining at the end of a plan year (or elected levels of coverage.
right to elect qualified HSA at the end of a grace period, if (iv) Alternatively, the $5,000 may be used
to reduce the required salary reduction
distributions described in section applicable) must be forfeited.
amount under the health FSA for all 2009
106(e). No qualified HSA distribution (o) FSA experience gains or participants (for example, a $500 health FSA
may be made in a plan year unless the forfeitures—(1) Experience gains in for the next year is priced at $480) or to
employer amends the health FSA general. An FSA experience gain reimburse claims incurred above the elective
written plan with respect to all (sometimes referred to as forfeitures in limit in 2010 as long as such reimbursements
employees, effective by the last day of the use-or-lose rule in paragraph (c) in are made on a reasonable and uniform level.
the plan year, to allow a qualified HSA this section) with respect to a plan year (p) Effective/applicability date. It is
distribution satisfying all the (plus any grace period following the end proposed that these regulations apply
requirements in this paragraph (n). See of a plan year described in paragraph (e) on and after plan years beginning on or
also section 106(e)(5)(B). In addition, a in § 1.125–1), equals the amount of the after January 1, 2009.
distribution with respect to an employee employer contributions, including
is not a qualified HSA distribution salary reduction contributions, and § 1.125–6 Substantiation of expenses for
after-tax employee contributions to the all cafeteria plans.
unless all of the following requirements
are satisfied— FSA minus the FSA’s total claims (a) Cafeteria plan payments and
(i) No qualified HSA distribution has reimbursements for the year. Experience reimbursements—(1) In general. A
been previously made on behalf of the gains (or forfeitures) may be— cafeteria plan may pay or reimburse
employee from this health FSA; (i) Retained by the employer only those substantiated expenses for
(ii) The employee elects to have the maintaining the cafeteria plan; or qualified benefits incurred on or after
employer make a qualified HSA (ii) If not retained by the employer, the later of the effective date of the
distribution from the health FSA to the may be used only in one or more of the cafeteria plan and the date the employee
HSA of the employee; following ways— is enrolled in the plan. This requirement
(iii) The distribution does not exceed (A) To reduce required salary applies to all qualified benefits offered
the lesser of the balance of the health reduction amounts for the immediately through the cafeteria plan. See
FSA on— following plan year, on a reasonable and paragraph (b) of this section for
(A) September 21, 2006; or uniform basis, as described in paragraph substantiation rules.
(B) The date of the distribution; (o)(2) of this section; (2) Expenses incurred—(i) Employees’
(iv) For purposes of this paragraph (B) Returned to the employees on a medical expenses must be incurred
(n)(1), balances as of any date are reasonable and uniform basis, as during the period of coverage. In order
determined on a cash basis, without described in paragraph (o)(2) of this for reimbursements to be excludible
taking into account expenses incurred section; or from gross income under section 105(b),
but not reimbursed as of a date, and (C) To defray expenses to administer the medical expenses reimbursed by an
applying the uniform coverage rule in the cafeteria plan. accident and health plan elected
paragraph (d) in this section; (2) Allocating experience gains among through a cafeteria plan must be
(v) The distribution is made no later employees on reasonable and uniform incurred during the period when the
than December 31, 2011; and basis. If not retained by the employer or participant is covered by the accident
(vi) The employer makes the used to defray expenses of and health plan. A participant’s period
distribution directly to the trustee of the administering the plan, the experience of coverage includes COBRA coverage.
employee’s HSA. gains must be allocated among See § 54.4980B–2 of this chapter.
(2) Taxation of qualified HSA employees on a reasonable and uniform Medical expenses incurred before the
distributions. A qualified HSA basis. It is permissible to allocate these later of the effective date of the plan and
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distribution from the health FSA amounts based on the different coverage the date the employee is enrolled in the
covering the participant to his or her levels of employees under the FSA. plan are not incurred during the period
HSA is a rollover to the HSA (as defined Experience gains allocated in for which the employee is covered by
in section 223(f)(5)) and thus is compliance with this paragraph (o) are the plan. However, the actual
generally not includible in gross not a deferral of the receipt of reimbursement of covered medical care
income. However, if the participant is compensation. However, in no case may expenses may be made after the
not an eligible individual (as defined in the experience gains be allocated among applicable period of coverage.

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43961

(ii) When medical expenses are the employee’s spouse or dependents) dependent care in-kind (for example,
incurred. For purposes of this rule, incurs medical expenses during the through an employer-maintained child
medical expenses are incurred when the period of coverage. This rule applies care facility), only dependent care
employee (or the employee’s spouse or even if the employee will not receive provided during the plan year of
dependents) is provided with the such amounts until the end or after the coverage is provided through a
medical care that gives rise to the end of the period. A plan under which dependent care assistance program
medical expenses, and not when the employees (or their spouses and within the meaning of section 129. See
employee is formally billed, charged for, dependents) will receive reimbursement also § 1.125–5 for FSA rules.
or pays for the medical care. for medical expenses up to a specified (iii) Period of coverage. In order for
(iii) Example. The following example amount and, if they incur no medical dependent care assistance through a
illustrates the rules in this paragraph expenses, will receive cash or any other cafeteria plan to be provided through a
(a)(2): benefit in lieu of the reimbursements is dependent care assistance program
Example. Medical expenses incurred after not a benefit qualifying for the exclusion eligible for the section 129 exclusion,
termination. (i) Employer E maintains a under sections 106 and 105(b). See the plan may not operate in a manner
cafeteria plan with a calendar year plan year. § 1.105–2. This is the case without that enables employees to purchase
The cafeteria plan provides that participation regard to whether the benefit was dependent care assistance only for
terminates when an individual ceases to be purchased with contributions made at periods during which the employees
an employee of Employer E, unless the the employer’s discretion, at the expect to receive dependent care
former employee elects to continue to employee’s discretion (for example, by assistance. If the period of coverage for
participate in the health FSA under the salary reduction election), or pursuant a dependent care assistance program
COBRA rules in § 54.4980B-2 of this chapter. to a collective bargaining agreement.
Employee G timely elects to salary reduce
offered through a cafeteria plan is
(iii) Other arrangements. twelve months (or, in the case of a short
$1,200 to participate in a health FSA for the
Arrangements formally outside of the plan year, at least equal to the short plan
2009 plan year. As of June 30, 2009,
Employee G has contributed $600 toward the cafeteria plan that adjust an employee’s year) and the plan does not permit an
health FSA, but incurred no medical compensation or an employee’s receipt employee to elect specific amounts of
expenses. On June 30, 2009, Employee G of any other benefits on the basis of the coverage, reimbursement, or salary
terminates employment and does not expenses incurred or reimbursements reduction for less than twelve months,
continue participation under COBRA. On the employee receives are considered in the plan is deemed not to operate to
July 15, 2009, G incurs a section 213(d) determining whether the enable employees to purchase coverage
medical expense of $500. reimbursements are through a plan
(ii) Under the rules in paragraph (a)(2) of
only for periods when dependent care
eligible for the exclusions under assistance will be received. See
this section, the cafeteria plan is prohibited sections 106 and 105(b).
from reimbursing any portion of the $500 paragraph (a) in § 1.125–2 and § 1.125–
(4) Reimbursements of dependent 4 regarding the revocation of elections
medical expense because, at the time the
medical expense is incurred, G is not a
care expenses—(i) Dependent care during the period of coverage on
participant in the cafeteria plan. expenses must be incurred. In order to account of changes in family status. See
satisfy section 129, dependent care paragraph (e) in this section for required
(3) Section 105(b) requirements for expenses may not be reimbursed before
reimbursement of medical expenses period of coverage for dependent care
the expenses are incurred. For purposes assistance.
through a cafeteria plan—(i) In general. of this rule, dependent care expenses
In order for medical care (iv) Examples. The following
are incurred when the care is provided examples illustrate the rules in
reimbursements paid to an employee and not when the employee is formally
through a cafeteria plan to be excludible paragraphs (a)(4)(i)–(iii) of this section:
billed, charged for, or pays for the
under section 105(b), the dependent care. Example 1. Initial non-refundable fee for
reimbursements must be paid pursuant (ii) Dependent care provided during child care. (i) Employer F maintains a
to an employer-funded accident and calendar year cafeteria plan, offering
the period of coverage. In order for
employees an election between cash and
health plan, as defined in section 105(e) dependent care assistance to be qualified benefits, including dependent care
and §§ 1.105–2 and 1.105–5. provided through a dependent care assistance. Employee M has a one-year old
(ii) Reimbursement exclusively for assistance program eligible for the dependent child. Employee M timely elected
section 213(d) medical expenses. A section 129 exclusion, the care must be $5,000 of dependent care assistance for 2009.
cafeteria plan benefit through which an provided to or on behalf of the During the entire 2009 plan year, Employee
employee receives reimbursements of employee during the period for which M satisfies all the requirements in section
medical expenses is excludable under the employee is covered by the program. 129 for dependent care assistance.
section 105(b) only if reimbursements For example, if for a plan year, an (ii) On February 1, 2009, Employee M pays
from the plan are made specifically to employee elects a dependent care an initial non-refundable fee of $500 to a
reimburse the employee for medical licensed child care center (unrelated to
assistance program providing for
Employer F or to Employee M), to reserve a
expenses (as defined in section 213(d)) reimbursement of dependent care space at the child care center for M’s child.
incurred by the employee or the expenses, only reimbursements for The child care center’s monthly charges for
employee’s spouse or dependents dependent care expenses incurred child care are $1,200. When the child care
during the period of coverage. Amounts during that plan year are provided from center first begins to care for M’s child, the
paid to an employee as reimbursement a dependent care assistance program $500 non-refundable fee is applied toward
are not paid specifically to reimburse within the scope of section 129. Also, the first month’s charges for child care.
the employee for medical expenses if for purposes of this rule, expenses (iii) On March 1, 2009, the child care
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the plan provides that the employee is incurred before the later of the center begins caring for Employee M’s child,
entitled, or operates in a manner that program’s effective date and the date the and continues to care for the child through
December 31, 2009. On March 1, 2009, M
entitles the employee, to receive the employee is enrolled in the program are pays the child care center $700 (the balance
amounts, in the form of cash (for not incurred during the period when the of the $1,200 in charges for child care to be
example, routine payment of salary) or employee is covered by the program. provided in March 2009). On April 1, 2009,
any other taxable or nontaxable benefit Similarly, if the dependent care M pays the child care center $1,200 for the
irrespective of whether the employee (or assistance program furnishes the child care to be provided in April 2009.

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43962 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

(iv) Dependent care expenses are incurred sets forth the substantiation been reimbursed and that the employee
when the services are provided. For requirements that a cafeteria plan must will not seek reimbursement from any
dependent care services provided in March satisfy before paying or reimbursing any other plan covering health benefits, the
2009, the $500 nonrefundable fee paid on expense for a qualified benefit. claim is fully substantiated without the
February 1, 2009, and the $700 paid on
(2) All claims must be substantiated. need for submission of a receipt by the
March 1, 2009 may be reimbursed on or after
the later of the date when substantiated or As a precondition of payment or employee or further review.
April 1, 2009. For dependent care services reimbursement of expenses for qualified (B) Example. The following example
provided in April 2009, the $1,200 paid on benefits, a cafeteria plan must require illustrates the rules in this paragraph
April 1, 2009 may be reimbursed on or after substantiation in accordance with this (b)(3):
the later of the date when substantiated or section. Substantiating only a Example. Explanation of benefits. (i)
May 1, 2009. percentage of claims, or substantiating During the plan year ending December 31,
Example 2. Non-refundable fee forfeited. only claims above a certain dollar 2009, Employee Q is a participant in the
Same facts as Example 1, except that the amount, fails to comply with the health FSA sponsored by Employer J and is
child care center never cared for M’s child
substantiation requirements in § 1.125– enrolled in Employer J’s accident and health
(who was instead cared for at Employer F’s
1 and this section. plan.
onsite child care facility). Because the child
(3) Substantiation by independent (ii) On March 1, 2009, Q visits a
care center never provided child care
third-party—(i) In general. All expenses physician’s office for medical care as defined
services to Employee M’s child, the $500
must be substantiated by information in section 213(d). The charge for the
non-refundable fee is not reimbursable.
physician’s services is $150. Under the plan,
from a third-party that is independent of
(v) Optional spend-down provision. Q is responsible for 20 percent of the charge
the employee and the employee’s for the physician’s services (that is, $30). Q
At the employer’s option, the written
spouse and dependents. The has sufficient FSA coverage for the $30
cafeteria plan may provide that
independent third-party must provide claim.
dependent care expenses incurred after
information describing the service or (iii) Employer J has coordinated with the
the date an employee ceases
product, the date of the service or sale, accident and health plan so that Employer J
participation in the cafeteria plan (for or its agent automatically receives an EOB
and the amount. Self-substantiation or
example, after termination) and through from the plan indicating that Q is responsible
self-certification of an expense by an
the last day of that plan year (or grace for payment of 20 percent of the $150
employee does not satisfy the
period immediately after that plan year) charged by the physician. Because Employer
substantiation requirements of this
may be reimbursed from unused J has received a statement from an
paragraph (b). The specific requirements independent third-party that Q has incurred
benefits, if all of the requirements of in sections 105(b), 129, and 137 must
section 129 are satisfied. a medical expense, the date the expense was
also be satisfied as a condition of incurred, and the amount of the expense, the
(vi) Example. The following example
reimbursing expenses for qualified claim is substantiated without the need for J
illustrates the rules in paragraph
benefits. For example, a health FSA to submit additional information regarding
(a)(4)(v) of this section:
does not satisfy the requirements of the expense. Employer J’s FSA reimburses Q
Example. Terminated employee’s post- section 105(b) if it reimburses the $30 medical expense without requiring Q
termination dependent care expenses. (i) For employees for expenses where the to submit a receipt or a statement from the
calendar year 2009, Employee X elects $5,000 employees only submit information physician. The substantiation rules in
salary reduction for dependent care paragraph (b) in this section are satisfied.
assistance through Employer G’s cafeteria
describing medical expenses, the
plan. X works for Employer G from January amount of the expenses and the date of (4) Advance reimbursement of
1 through June 30, 2009, when X terminates the expenses but fail to provide a expenses for qualified benefits
employment. As of June 30, 2009, X had paid statement from an independent third- prohibited. Reimbursing expenses
$2,500 in salary reduction and had incurred party (either automatically or before the expense has been incurred or
and was reimbursed for $2,000 of dependent subsequent to the transaction) verifying before the expense is substantiated fails
care expenses. the expenses. Under § 1.105–2, all to satisfy the substantiation
(ii) X does not work again until October 1, amounts paid under a plan that permits requirements in § 1.105–2, § 1.125–1
2009, when X begins work for Employer H. self-substantiation or self-certification and this section.
X was employed by Employer H from
October 1, 2009 through December 31, 2009.
are includible in gross income, (5) Purported loan from employer to
During this period, X also incurred $500 of including amounts reimbursed for employee. In determining whether,
dependent care expenses. During all the medical expenses, whether or not under all the facts and circumstances,
periods of employment in 2009, X satisfied substantiated. See paragraph (m) in employees are being reimbursed for
all requirements in section 129 for excluding § 1.125–5 for additional substantiation unsubstantiated claims, special scrutiny
payments for dependent care assistance from rules for limited-purpose and post- will be given to other arrangements such
gross income. deductible health FSAs. as employer-to-employee loans based on
(iii) Employer G’s cafeteria plan allows (ii) Rules for substantiation of health actual or projected employee claims.
terminated employees to ‘‘spend down’’ FSA claims using an explanation of (6) Debit cards. For purposes of this
unused salary reduction amounts for benefits provided by an insurance section, a debit card is a debit card,
dependent care assistance, if all requirements
company—(A) Written statement from credit card, or stored value card. See
of section 129 are satisfied. After X’s claim
for $500 of dependent care expenses is an independent third-party. If the also paragraphs (c) through (g) of this
substantiated, Employer G’s cafeteria plan employer is provided with information section for additional rules on payments
reimburses X for $500 (the remaining from an independent third-party (such or reimbursements made through debit
balance) of dependent care expenses incurred as an ‘‘explanation of benefits’’ (EOB) cards.
during X’s employment for Employer H from an insurance company) indicating (c) Debit cards–overview—(1)
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between October 1, 2009 and December 31, the date of the section 213(d) medical Mandatory rules for all debit cards
2009. Employer G’s cafeteria plan and care and the employee’s responsibility usable to pay or reimburse medical
operation are consistent with section 125. for payment for that medical care (that expenses. Paragraph (d) of this section
(b) Rules for claims substantiation for is, coinsurance payments and amounts sets forth the mandatory procedures for
cafeteria plans—(1) Substantiation below the plan’s deductible), and the debit cards to substantiate section
required before reimbursing expenses employee certifies that any expense 213(d) medical expenses. These rules
for qualified benefits. This paragraph (b) paid through the health FSA has not apply to all debit cards used to pay or

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reimburse medical expenses. Paragraph (5) The employer limits use of the (iv) of this section, the employee
(e) of this section sets forth additional debit card to— remains indebted to the employer for
substantiation rules that may be used for (i) Physicians, dentists, vision care improper payments, the employer,
medical expenses incurred at medical offices, hospitals, other medical care consistent with its business practice,
care providers and certain stores with providers (as identified by the merchant treats the improper payment as it would
the Drug Stores and Pharmacies category code); any other business indebtedness.
merchant category code. Paragraph (f) in (ii) Stores with the merchant category (e) Substantiation of expenses
this section sets forth the requirements code for Drugstores and Pharmacies if, incurred at medical care providers and
for an inventory information approval on a location by location basis, 90 certain other stores with Drug Stores
system which must be used to percent of the store’s gross receipts and Pharmacies merchant category
substantiate medical expenses incurred during the prior taxable year consisted code—(1) In general. A health FSA
at merchants or service providers that of items which qualify as expenses for paying or reimbursing section 213(d)
are not medical care providers or certain medical care described in section medical expenses through a debit card
stores with the Drug Stores and 213(d); and is permitted to comply with the
Pharmacies merchant category code and (iii) Stores that have implemented the substantiation provisions of this
that may be used for medical expenses inventory information approval system paragraph (e), instead of complying with
incurred at all merchants. under paragraph (f). the provisions of paragraph (f), for
(2) Debit cards used for dependent (6) The employer substantiates claims medical expenses incurred at providers
care assistance. Paragraph (g) of this based on payments to medical care described in paragraph (e)(2) of this
section sets forth additional rules for providers and stores described in section.
debit cards usable for reimbursing paragraphs (d)(5)(i) and (ii) of this (2) Medical care providers and certain
dependent care expenses. section in accordance with either other stores with Drug Stores and
(3) Additional guidance. The paragraph (e) or paragraph (f) of this Pharmacies merchant category code.
Commissioner may prescribe additional section. Medical expenses may be substantiated
(7) The employer follows all of the using the methods described in
guidance of general applicability,
following correction procedures for any paragraph (e)(3) of this section if
published in the Internal Revenue
improper payments using the debit incurred at physicians, pharmacies,
Bulletin (see § 601.601(d)(2)(ii)(b) of this
card— dentists, vision care offices, hospitals,
chapter), to provide additional rules for
(i) Until the amount of the improper other medical care providers (as
debit cards.
payment is recovered, the debit card identified by the merchant category
(d) Mandatory rules for all debit cards must be de-activated and the employee code) and at stores with the Drug Stores
usable to pay or reimburse medical must request payments or and Pharmacies merchant category
expenses. A health FSA paying or reimbursements of medical expenses code, if, on a store location-by-location
reimbursing section 213(d) medical from the health FSA through other basis, 90 percent of the store’s gross
expenses through a debit card must methods (for example, by submitting receipts during the prior taxable year
satisfy all of the following receipts or invoices from a merchant or consisted of items which qualify as
requirements— service provider showing the employee expenses for medical care described in
(1) Before any employee participating incurred a section 213(d) medical section 213(d).
in a health FSA receives the debit card, expense); (3) Claims substantiation for
the employee agrees in writing that he (ii) The employer demands that the copayment matches, certain recurring
or she will only use the card to pay for employee repay the cafeteria plan an medical expenses and real-time
medical expenses (as defined in section amount equal to the improper payment; substantiation. If all of the requirements
213(d)) of the employee or his or her (iii) If, after the demand for repayment in this paragraph (e)(3) are satisfied,
spouse or dependents, that he or she of improper payment (as described in copayment matches, certain recurring
will not use the debit card for any paragraph (d)(7)(ii) of this section), the medical expenses and medical expenses
medical expense that has already been employee fails to repay the amount of substantiated in real-time are
reimbursed, that he or she will not seek the improper charge, the employer substantiated without the need for
reimbursement under any other health withholds the amount of the improper submission of receipts or further review.
plan for any expense paid for with a charge from the employee’s pay or other (i) Matching copayments—multiples
debit card, and that he or she will compensation, to the full extent allowed of five or fewer. If an employer’s
acquire and retain sufficient by applicable law; accident or health plan covering the
documentation (including invoices and (iv) If any portion of the improper employee (or the employee’s spouse or
receipts) for any expense paid with the payment remains outstanding after dependents) has copayments in specific
debit card. attempts to recover the amount (as dollar amounts, and the dollar amount
(2) The debit card includes a described in paragraph (d)(7)(ii) and (iii) of the transaction at a medical care
statement providing that the agreements of this section), the employer applies a provider equals an exact multiple of not
described in paragraph (d)(1) of this claims substitution or offset to resolve more than five times the dollar amount
section are reaffirmed each time the improper payments, such as a of the copayment for the specific service
employee uses the card. reimbursement for a later substantiated (for example, pharmacy benefit
(3) The amount available through the expense claim is reduced by the amount copayment, copayment for a physician’s
debit card equals the amount elected by of the improper payment. So, for office visit) under the accident or health
the employee for the health FSA for the example, if an employee has received an plan covering the specific employee-
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cafeteria plan year, and is reduced by improper payment of $200 and cardholder, then the charge is fully
amounts paid or reimbursed for section subsequently submits a substantiated substantiated without the need for
213(d) medical expenses incurred claim for $250 incurred during the same submission of a receipt or further
during the plan year. coverage period, a reimbursement for review.
(4) The debit card is automatically $50 is made; and (A) Tiered copayments. If a health
cancelled when the employee ceases to (v) If, after applying all the procedures plan has multiple copayments for the
participate in the health FSA. described in paragraph (d)(7)(ii) through same benefit, (for example, tiered

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43964 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

copayments for a pharmacy benefit), substantiation rules in this paragraph (e) items purchased against a list of items,
exact matches of multiples or for payment of recurring expenses that the purchase of which qualifies as
combinations of up to five copayments match expenses previously approved as expenses for medical care under section
are similarly fully substantiated without to amount, medical care provider and 213(d) (including nonprescription
the need for submission of a receipt or time period (for example, for an medications).
further review. employee who refills a prescription (ii) The section 213(d) medical
(B) Copayment match must be exact drug on a regular basis at the same expenses are totaled and the merchant’s
multiple. If the dollar amount of the provider and in the same amount). The or payment card processor’s system
transaction is not an exact multiple of payment is substantiated without the approves the use of the card only for the
the copayment (or an exact match of a need for submission of a receipt or amount of the section 213(d) medical
multiple or combination of different further review. expenses eligible for coverage under the
copayments for a benefit in the case of (5) Real-time substantiation. If a third health FSA (taking into consideration
multiple copayments), the transaction party that is independent of the the uniform coverage rule in paragraph
must be treated as conditional pending employee and the employee’s spouse (d) of § 1.125–5);
confirmation of the charge, even if the and dependents (for example, medical (iii) If the transaction is only partially
amount is less than five times the care provider, merchant, or pharmacy approved, the employee is required to
copayment. benefit manager) provides, at the time tender additional amounts, resulting in
(C) No match for multiple of six or and point of sale, information to verify a split-tender transaction. For example,
more times copayment. If the dollar to the employer (including if, after matching inventory information,
amount of the transaction at a medical electronically by email, the internet, it is determined that all items purchased
care provider equals a multiple of six or intranet or telephone) that the charge is are section 213(d) medical expenses, the
more times the dollar amount of the for a section 213(d) medical expense, entire transaction is approved, subject to
copayment for the specific service, the the expense is substantiated without the the coverage limitations of the health
transaction must be treated as need for further review. FSA;
conditional pending confirmation of the (6) Substantiation requirements for all (iv) If, after matching inventory
charge by the submission of additional other medical expenses paid or information, it is determined that only
third-party information. See paragraph reimbursed through a health FSA debit some of the items purchased are section
(d) of this section. In the case of a plan card. All other charges to the debit card 213(d) medical expenses, the
with multiple copayments for the same (other than substantiated copayments, transaction is approved only as to the
benefit, if the dollar amount of the recurring medical expenses or real-time section 213(d) medical expenses. In this
transaction exceeds five times the substantiation, or charges substantiated case, the merchant or service-provider
maximum copayment for the benefit, through the inventory information must request additional payment from
the transaction must also be treated as approval system described in paragraph the employee for the items that do not
conditional pending confirmation of the (f) of this section) must be treated as satisfy the definition of medical care
charge by the submission of additional conditional, pending substantiation of under section 213(d);
third-party information. In these cases, the charge through additional (v) The merchant or service-provider
the employer must require that independent third-party information must also request additional payment
additional third-party information, such describing the goods or services, the from the employee if the employee does
as merchant or service provider receipts, date of the service or sale and the not have sufficient health FSA coverage
be submitted for review and amount of the transaction. All such to purchase the section 213(d) medical
substantiation, and the third-party debit card payments must be items;
information must satisfy the substantiated, regardless of the amount (vi) Any attempt to use the card at
requirements in paragraph (b)(3) of this of the payment. non-participating merchants or service-
section. (f) Inventory information approval providers must fail.
(D) Independent verification of system—(1) In general. An inventory (3) Employer’s responsibility for
copayment required. The copayment information approval system that ensuring inventory information
schedule required under the accident or complies with this paragraph (f) may be approval system’s compliance with
health plan must be independently used to substantiate payments made § 1.105–2, § 1.125–1, § 1.125–6 and
verified by the employer. Statements or using a debit card, including payments recordkeeping requirements. An
other representations by the employee at merchants and service providers that employer that uses the inventory
are not sufficient. Self-substantiation or are not described in paragraph (e)(2) of information approval system must
self-certification of an employee’s this section. Debit card transactions ensure that the inventory information
copayment in connection with using this system are fully substantiated approval system complies with the
copayment matching procedures without the need for submission of a requirements in §§ 1.105–2, 1.125–1,
through debit cards or otherwise does receipt by the employee or further and § 1.125–6 for substantiating, paying
not constitute substantiation. If a plan’s review. or reimbursing section 213(d) medical
copayment matching system relies on an (2) Operation of inventory information expenses and with the recordkeeping
employee to provide a copayment approval system. An inventory requirements in section 6001.
amount without verification of the information approval system must (g) Debit cards used to pay or
amount, claims have not been operate in the manner described in this reimburse dependent care assistance—
substantiated, and all amounts paid paragraph (f)(2). (1) In general. An employer may use a
from the plan are included in gross (i) When an employee uses the card, debit card to provide benefits under its
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income, including amounts paid for the payment card processor’s or dependent care assistance program
medical care whether or not participating merchant’s system collects (including a dependent care assistance
substantiated. See paragraph (b) in this information about the items purchased FSA). However, dependent care
section. using the inventory control information expenses may not be reimbursed before
(4) Certain recurring medical (for example, stock keeping units the expenses are incurred. See
expenses. Automatic payment or (SKUs)). The system compares the paragraph (a)(4) in this section. Thus, if
reimbursement satisfies the inventory control information for the a dependent care provider requires

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Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules 43965

payment before the dependent care Example. Recurring dependent care apply for purposes of section 125(b), (c),
services are provided, the expenses expenses. (i) Employer K sponsors a (e) and (g) and this section.
cannot be reimbursed at the time of dependent care assistance FSA through its (2) Compensation. The term
payment through use of a debit card or cafeteria plan. Salary reduction amounts for
compensation means compensation as
participating employees are made on a
otherwise. weekly payroll basis, which are available for defined in section 415(c)(3).
(2) Reimbursing dependent care dependent care coverage on a weekly basis. (3) Highly compensated individual. (i)
assistance through a debit card. An As a result, the amount of available In general. The term highly
employer offering a dependent care dependent care coverage equals the compensated individual means an
assistance FSA may adopt the following employee’s salary reduction amount minus individual who is—
method to provide reimbursements for claims previously paid from the plan. (A) An officer;
dependent care expenses through a Employer K has adopted a payment card (B) A five percent shareholder (as
debit card— program for its dependent care FSA. defined in paragraph (a)(8) of this
(ii) For the plan year ending December 31,
(i) At the beginning of the plan year 2009, Employee F is a participant in the
section); or
or upon enrollment in the dependent dependent care FSA and elected $5,000 of (C) Highly compensated.
care assistance program, the employee dependent care coverage. Employer K (ii) Spouse or dependent. A spouse or
pays initial expenses to the dependent reduces F’s salary by $96.15 on a weekly a dependent of any highly compensated
care provider and substantiates the basis to pay for coverage under the individual described in (a)(3)(i) of this
initial expenses by submitting to the dependent care FSA. section is a highly compensated
employer or plan administrator a (iii) At the beginning of the 2009 plan year, individual. Section 125(e).
statement from the dependent care F is issued a debit card with a balance of (4) Highly compensated participant.
provider substantiating the dates and zero. F’s childcare provider, ABC Daycare
The term highly compensated
Center, requires a $250 advance payment at
amounts for the services provided. the beginning of the week for dependent care participant means a highly compensated
(ii) After the employer or plan services that will be provided during the individual who is eligible to participate
administrator receives the week. The dependent care services provided in the cafeteria plan.
substantiation (but not before the date for F by ABC qualify for reimbursement (5) Nonhighly compensated
the services are provided as indicated under section 129. However, because as of individual. The term nonhighly
by the statement provided by the the beginning of the plan year, no services compensated individual means an
dependent care provider), the plan have yet been provided, F cannot be individual who is not a highly
makes available through the debit card reimbursed for any of the amounts until the compensated individual.
an amount equal to the lesser of— end of the first week of the plan year (that
is, the week ending January 5, 2009), after the
(6) Nonhighly compensated
(A) The previously incurred and services have been provided. participant. The term nonhighly
substantiated expense; or (iv) F submits a claim for reimbursement compensated participant means a
(B) The employee’s total salary that includes a statement from ABC with a participant who is not a highly
reduction amount to date. description of the services, the amount of the compensated participant.
(iii) The card may be used to pay for services, and the dates of the services. (7) Officer. The term officer means
subsequently incurred dependent care Employer K increases the balance of F’s any individual or participant who for
expenses. payment card to $96.15 after the services the preceding plan year (or the current
(iv) The amount available through the have been provided (i.e., the lesser of F’s plan year in the case of the first year of
salary reduction to date or the incurred
card may be increased in the amount of dependent care expenses). F uses the card to
employment) was an officer. Whether an
any additional dependent care expenses pay ABC $96.15 on the first day of the next individual is an officer is determined
only after the additional expenses have week (January 8, 2009) and pays ABC the based on all the facts and
been incurred. remaining balance due for that week circumstances, including the source of
(3) Substantiating recurring ($153.85) by check. the individual’s authority, the term for
dependent care expenses. Card (v) To the extent that this card transaction which he or she is elected or appointed,
transactions that collect information and each subsequent transaction is with ABC and the nature and extent of his or her
matching expenses previously and is for an amount equal to or less than the duties. Generally, the term officer means
substantiated and approved as to previously substantiated amount, the charges an administrative executive who is in
are fully substantiated without the need for
dependent care provider and time the submission by F of a statement from the
regular and continued service. The term
period may be treated as substantiated provider or further review by the employer. officer implies continuity of service and
without further review if the transaction However, the subsequent amount is not made excludes individuals performing
is for an amount equal to or less than available on the card until the end of the services in connection with a special
the previously substantiated expenses. week when the services have been provided. and single transaction. An individual
Similarly, dependent care expenses Employer K’s dependent care debit card who merely has the title of an officer but
previously substantiated and approved satisfies the substantiation requirements of not the authority of an officer, is not an
through nonelectronic methods may this paragraph (g). officer. Similarly, an individual without
also be treated as substantiated without (h) Effective/applicability date. It is the title of an officer but who has the
further review. In both cases, if there is proposed that these regulations apply authority of an officer is an officer. Sole
an increase in previously substantiated on and after plan years beginning on or proprietorships, partnerships,
amounts or a change in the dependent after January 1, 2009. However, the associations, trusts and labor
care provider, the employee must effective dates for the previously issued organizations also may have officers.
submit a statement or receipt from the guidance on debit cards, which is See §§ 301.7701–1 through –3
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dependent care provider substantiating incorporated in this section, remain (8) Five percent shareholder. A five
the claimed expenses before amounts applicable. percent shareholder is an individual
relating to the increased amounts or who in either the preceding plan year or
new providers may be added to the § 1.125–7 Cafeteria plan nondiscrimination current plan year owns more than five
card. rules. percent of the voting power or value of
(4) Example. The following example (a) Definitions—(1) In general. The all classes of stock of the employer,
illustrates the rules in this paragraph (g): definitions set forth in this paragraph (a) determined without attribution.

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43966 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

(9) Highly compensated. The term in § 1.410(b)–4(b), and the group of (C) Employees participating in the
highly compensated means any employees included in the classification cafeteria plan under a COBRA
individual or participant who for the satisfies the safe harbor percentage test continuation provision.
preceding plan year (or the current plan or the unsafe harbor percentage (iv) Examples. The following
year in the case of the first year of component of the facts and examples illustrate the rules in
employment) had compensation from circumstances test in § 1.410(b)–4(c). (In paragraph (b) of this section:
the employer in excess of the applying the § 1.410(b)–4 test, substitute Example 1. Same qualified benefit for same
compensation amount specified in highly compensated individual for salary reduction amount. Employer A has
section 414(q)(1)(B), and, if elected by highly compensated employee and one employer-provided accident and health
the employer, was also in the top-paid substitute nonhighly compensated insurance plan. The cost to participants
group of employees (determined by individual for nonhighly compensated electing the accident and health plan is
reference to section 414(q)(3)) for such employee). $10,000 per year for single coverage. All
employees have the same opportunity to
preceding plan year (or for the current (2) Deadline for participation in salary reduce $10,000 for accident and health
plan year in the case of the first year of cafeteria plan. Any employee who has plan. The cafeteria plan satisfies the
employment). completed three years of employment eligibility test.
(10) Key employee. A key employee is Example 2. Same qualified benefit for
(and who satisfies any conditions for
a participant who is a key employee unequal salary reduction amounts. Same
participation in the cafeteria plan that
within the meaning of section 416(i)(1) facts as Example 1 except the cafeteria plan
are not related to completion of a offers nonhighly compensated employees the
at any time during the preceding plan
requisite length of employment) must be election to salary reduce $10,000 to pay
year. A key employee covered by a
permitted to elect to participate in the premiums for single coverage. The cafeteria
collective bargaining agreement is a key
cafeteria plan no later than the first day plan provides an $8,000 employer flex-credit
employee. to highly compensated employees to pay a
(11) Collectively bargained plan. A of the first plan year beginning after the
date the employee completed three portion of the premium, and provides an
collectively bargained plan is a plan or election to them to salary reduce $2,000 to
the portion of a plan maintained under years of employment (unless the
pay the balance of the premium. The
an agreement which is a collective employee separates from service before
cafeteria plan fails the eligibility test.
bargaining agreement between employee the first day of that plan year). Example 3. Accident and health plans of
representatives and one or more (3) The safe harbor percentage test— unequal value. Employer B’s cafeteria plan
employers, if there is evidence that (i) In general. For purposes of the safe offers two employer-provided accident and
cafeteria plan benefits were the subject harbor percentage test and the unsafe health insurance plans: Plan X, available
harbor percentage component of the only to highly compensated participants, is a
of good faith bargaining between such
low-deductible plan. Plan Y, available only
employee representatives and such facts and circumstances test, if the
to nonhighly compensated participants, is a
employer or employers. cafeteria plan provides that only high deductible plan (as defined in section
(12) Year of employment. For employees who have completed three 223(c)(2)). The annual premium for single
purposes of section 125(g)(3)(B)(i), a years of employment are permitted to coverage under Plan X is $15,000 per year,
year of employment is determined by participate in the plan, employees who and $8,000 per year for Plan Y. Employer B’s
reference to the elapsed time method of have not completed three years of cafeteria plan provides that highly
crediting service. See § 1.410(a)–7. employment may be excluded from compensated participants may elect salary
(13) Premium-only-plan. A premium- consideration. However, if the cafeteria reduction of $15,000 for coverage under Plan
only-plan is described in paragraph X, and that nonhighly compensated
plan provides that employees are
participants may elect salary reduction of
(a)(5) in § 1.125–1. allowed to participate before completing $8,000 for coverage under Plan Y. The
(14) Statutory nontaxable benefits. three years of employment, all cafeteria plan fails the eligibility test.
Statutory nontaxable benefits are employees with less than three years of Example 4. Accident and health plans of
qualified benefits that are excluded from employment must be included in unequal value for unequal salary reduction
gross income (for example, an employer- applying the safe harbor percentage test amounts. Same facts as Example 3, except
provided accident and health plan and the unsafe harbor percentage that the amount of salary reduction for highly
excludible under section 106 or a component of the facts and compensated participants to elect Plan X is
dependent care assistance program $8,000. The cafeteria plan fails the eligibility
circumstances test. See paragraph (g) of
excludible under section 129). Statutory test.
this section for a permissive
nontaxable benefits also include group- disaggregation rule. (c) Nondiscrimination as to
term life insurance on the life of an (ii) Employees excluded from contributions and benefits—(1) In
employee includible in the employee’s consideration. In addition, for purposes general. A cafeteria plan must not
gross income solely because the of the safe harbor percentage test and discriminate in favor of highly
coverage exceeds the limit in section the unsafe harbor percentage component compensated participants as to
79(a). of the facts and circumstances test, the contributions and benefits for a plan
(15) Total benefits. Total benefits are following employees are excluded from year.
qualified benefits and permitted taxable (2) Benefit availability and benefit
consideration—
benefits. election. A cafeteria plan does not
(b) Nondiscrimination as to (A) Employees (except key discriminate with respect to
eligibility—(1) In general. A cafeteria employees) covered by a collectively contributions and benefits if either
plan must not discriminate in favor of bargained plan as defined in paragraph qualified benefits and total benefits, or
highly compensated individuals as to (a)(11) of this section; employer contributions allocable to
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eligibility to participate for that plan (B) Employees who are nonresident statutory nontaxable benefits and
year. A cafeteria plan does not aliens and receive no earned income employer contributions allocable to total
discriminate in favor of highly (within the meaning of section benefits, do not discriminate in favor of
compensated individuals if the plan 911(d)(2)) from the employer which highly compensated participants. A
benefits a group of employees who constitutes income from sources within cafeteria plan must satisfy this
qualify under a reasonable classification the United States (within the meaning of paragraph (c) with respect to both
established by the employer, as defined section 861(a)(3)); and benefit availability and benefit

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utilization. Thus, a plan must give each safe harbor for premium-only-plans in plan provided by Employer E. All 10
similarly situated participant a uniform paragraph (f) of this section. employees elect $8,000 salary reduction for
opportunity to elect qualified benefits, (2) Example. The following example the major medical plan.
and the actual election of qualified illustrates the rules in paragraph (d) of (ii) The cafeteria plan satisfies the section
125(g)(2) safe harbor for cafeteria plans
benefits through the plan must not be this section: providing health benefits.
disproportionate by highly compensated Example. (i) Key employee concentration
participants (while other participants test. Employer D’s cafeteria plan offers all (f) Safe harbor test for premium-only-
elect permitted taxable benefits). employees an election between taxable plans—(1) In general. A premium-only-
Qualified benefits are benefits and qualified benefits. The cafeteria plan (as defined in paragraph (a)(13) of
disproportionately elected by highly plan satisfies the eligibility test in paragraph this section) is deemed to satisfy the
compensated participants if the (b) of this section. Employer D has two key nondiscrimination rules in section
aggregate qualified benefits elected by employees and four nonhighly compensated 125(c) and this section for a plan year
highly compensated participants, employees. The key employees each elect if, for that plan year, the plan satisfies
$2,000 of qualified benefits. Each nonhighly the safe harbor percentage test for
measured as a percentage of the
compensated employee also elects $2,000 of
aggregate compensation of highly eligibility in paragraph (b)(3) of this
qualified benefits. The qualified benefits are
compensated participants, exceed the statutory nontaxable benefits. section.
aggregate qualified benefits elected by (ii) Key employees receive $4,000 of (2) Example. The following example
nonhighly compensated participants statutory nontaxable benefits and nonhighly illustrates the rules in paragraph (f) of
measured as a percentage of the compensated employees receive $8,000 of this section:
aggregate compensation of nonhighly statutory nontaxable benefits, for a total of Example. Premium-only-plan. (i) Employer
compensated participants. A plan must $12,000. Key employees receive 33 percent of F’s cafeteria plan is a premium-only-plan (as
also give each similarly situated statutory nontaxable benefits (4,000/12,000). defined in paragraph (a)(13) of this section).
Because the cafeteria plan provides more The written cafeteria plan offers one
participant a uniform election with
than 25 percent of the aggregate of statutory employer-provided accident and health plan
respect to employer contributions, and nontaxable benefits to key employees, the
the actual election with respect to and offers all employees the election to salary
plan fails the key employee concentration reduce same amount or same percentage of
employer contributions for qualified test. the premium for self-only or family coverage.
benefits through the plan must not be All key employees and all highly
disproportionate by highly compensated (e) Safe harbor for cafeteria plans
providing health benefits—(1) In compensated employees elect salary
participants (while other participants reduction for the accident and health plan,
elect to receive employer contributions general. A cafeteria plan that provides
but only 20 percent of nonhighly
as permitted taxable benefits). Employer health benefits is not treated as
compensated employees elect the accident
contributions are disproportionately discriminatory as to benefits and and health plan.
utilized by highly compensated contributions if:
(i) Contributions under the plan on (ii) The premium-only-plan satisfies
participants if the aggregate the nondiscrimination rules in section
behalf of each participant include an
contributions utilized by highly 125(b) and (c) and this section.
amount which equals 100 percent of the
compensated participants, measured as (g) Permissive disaggregation for
cost of the health benefit coverage under
a percentage of the aggregate nondiscrimination testing—(1) General
the plan of the majority of the highly
compensation of highly compensated rule. If a cafeteria plan benefits
compensated participants similarly
participants, exceed the aggregate employees who have not completed
situated, or equals or exceeds 75 percent
contributions utilized by nonhighly three years of employment, the cafeteria
of the cost of the health benefit coverage
compensated participants measured as a plan is permitted to test for
of the participant (similarly situated)
percentage of the aggregate nondiscrimination under this section as
having the highest cost health benefit
compensation of nonhighly if the plan were two separate plans—
coverage under the plan, and
compensated participants. (i) One plan benefiting the employees
(3) Example. The following example (ii) Contributions or benefits under
the plan in excess of those described in who completed one day of employment
illustrates the rules in paragraph (c) of but less than three years of employment;
this section: paragraph (e)(1)(i) of this section bear a
uniform relationship to compensation. and
Example. Contributions and benefits test. (2) Similarly situated. In determining (ii) Another plan benefiting the
Employer C’s cafeteria plan satisfies the which participants are similarly employees who have completed three
eligibility test in paragraph (b) of this section. years of employment.
Highly compensated participants in the situated, reasonable differences in plan
cafeteria plan elect aggregate qualified benefits may be taken into account (for (2) Disaggregated plans tested
benefits equaling 5 percent of aggregate example, variations in plan benefits separately for eligibility test and
compensation; nonhighly compensated offered to employees working in contributions and benefits test. If a
participants elect aggregate qualified benefits different geographical locations or to cafeteria plan is disaggregated into two
equaling 10 percent of aggregate employees with family coverage versus separate plans for purposes of
compensation. Employer C’s cafeteria plan employee-only coverage). nondiscrimination testing, the two
passes the contribution and benefits test. separate plans must be tested separately
(3) Health benefits. Health benefits for
(d) Key employees—(1) In general. If purposes of this rule are limited to for both the nondiscrimination as to
for any plan year, the statutory major medical coverage and exclude eligibility test in paragraph (b) of this
nontaxable benefits provided to key dental coverage and health FSAs. section and the nondiscrimination as to
employees exceed 25 percent of the (4) Example. The following example contributions and benefits test in
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aggregate of statutory nontaxable illustrates the rules in paragraph (e) of paragraph (c) of this section.
benefits provided for all employees this section: (h) Optional aggregation of plans for
through the cafeteria plan, each key Example. (i) All 10 of Employer E’s
nondiscrimination testing. An employer
employee includes in gross income an employees are eligible to elect between who sponsors more than one cafeteria
amount equaling the maximum taxable permitted taxable benefits and salary plan is permitted to aggregate two or
benefits that he or she could have reduction of $8,000 per plan year for self- more of the cafeteria plans for purposes
elected for the plan year. However, see only coverage in the major medical health of nondiscrimination testing. If two or

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43968 Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / Proposed Rules

more cafeteria plans are aggregated into cafeteria plan. During the 2009 plan year, participant or key employee) who elects
a combined plan for this purpose, the Employee J was an employee the entire qualified benefits is not treated as
combined plan must satisfy the calendar year, Employee K was an employee having received taxable benefits offered
from May 1, through August 31, 2009, and
nondiscrimination as to eligibility test through the plan, and thus the qualified
Employee L worked from January 1, 2009 to
in paragraph (b) of this section and the April 15, 2009, when he retired.
benefits elected by the employee are not
nondiscrimination as to contributions (ii) Nondiscrimination testing for the 2009 includible in the employee’s gross
and benefits test in paragraph (c) of this plan year must be performed on December income merely because of the
section, as though the combined plan 31, 2009, taking into account employees J, K, availability of taxable benefits. But see
were a single plan. Thus, for example, and L’s compensation in the preceding year. paragraph (j) in § 1.125–1 on
in order to satisfy the benefit availability (k) Discrimination in actual operation nondiscrimination rules for sections
and benefit election requirements in prohibited. In addition to not 79(d), 105(h), 129(d), and 137(c)(2), and
paragraph (c)(2) of this section, the discriminating as to either benefit limitations on exclusion.
combined plan must give each similarly availability or benefit utilization, a (2) Discriminatory cafeteria plan. A
situated participant a uniform cafeteria plan must not discriminate in highly compensated participant or key
opportunity to elect qualified benefits favor of highly compensated employee participating in a
and the actual election of qualified participants in actual operation. For discriminatory cafeteria plan must
benefits by highly compensated example, a plan may be discriminatory include in gross income (in the
participants must not be in actual operation if the duration of the participant’s taxable year within which
disproportionate. However, if a plan (or of a particular nontaxable ends the plan year with respect to
principal purpose of the aggregation is benefit offered through the plan) is for which an election was or could have
to manipulate the nondiscrimination a period during which only highly been made) the value of the taxable
testing requirements or to otherwise compensated participants utilize the benefit with the greatest value that the
discriminate in favor of highly plan (or the benefit). See also the key employee could have elected to receive,
compensated individuals or employee concentration test in section even if the employee elects to receive
participants, the plans will not be 125(b)(2). only the nontaxable benefits offered.
permitted to be aggregated for (l) Anti-abuse rule—(1) Interpretation. (n) Employer contributions to
nondiscrimination testing. The provisions of this section must be employees’ Health Savings Accounts. If
(i) Employees of certain controlled interpreted in a reasonable manner an employer contributes to employees’
groups. All employees who are treated consistent with the purpose of Health Savings Accounts (HSAs)
as employed by a single employer under preventing discrimination in favor of through a cafeteria plan (as defined in
section 414(b), (c), (m), or (o) are treated highly compensated individuals, highly § 54.4980G–5 of this chapter) those
as employed by a single employer for compensated participants and key contributions are subject to the
purposes of section 125. Section employees. nondiscrimination rules in section 125
125(g)(4); section 414(t). (2) Change in plan testing procedures. and this section and are not subject to
(j) Time to perform nondiscrimination A plan will not be treated as satisfying the comparability rules in section
testing—(1) In general. the requirements of this section if there 4980G. See §§ 54.4980G–0 through
Nondiscrimination testing must be are repeated changes to plan testing 54.4980G–5 of this chapter.
performed as of the last day of the plan procedures or plan provisions that have (o) Effective/applicability date. It is
year, taking into account all non- the effect of manipulating the proposed that these regulations apply
excludable employees (or former nondiscrimination testing requirements on and after plan years beginning on or
employees) who were employees on any of this section, if a principal purpose of after January 1, 2009.
day during the plan year. the changes was to achieve this result.
(2) The following example illustrates (m) Tax treatment of benefits in a Kevin M. Brown,
the rules in paragraph (j) of this section: cafeteria plan—(1) Nondiscriminatory Deputy Commissioner for Services and
cafeteria plan. A participant in a Enforcement.
Example. When to perform discrimination
testing. (i) Employer H employs three nondiscriminatory cafeteria plan [FR Doc. E7–14827 Filed 8–3–07; 8:45 am]
employees and maintains a calendar year (including a highly compensated BILLING CODE 4830–01–P
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