An Internal Revenue Code Section 125 Cafeteria Plan is a method of allowing employees to pay for qualified benefits on a pre-tax basis. In its simplest form, it is a premium only plan, which allows employees to pay for health insurance premiums before tax. In its most complicated form, an employer may offer employees flex credits to select among various benefits or a cash-out option.

Qualified Benefits

Qualified benefits that may be offered through a cafeteria plan include:

• Accident and health benefits
• Adoption assistance plans
• Dependent care assistance plans
• Group-term life insurance coverage
• Health Savings Accounts (HSAs)

Benefits that are not permitted under a cafeteria plan include: long-term care insurance, Archer Medical Savings Accounts (MSAs), educational assistance, and moving expenses.

Written Plan Document Requirement

The Internal Revenue Code requires that a cafeteria plan be in writing prior to the plan's effective date. If a plan is not in writing or does not operate according to its written document, the newly proposed rules issued in 2007 indicate that the plan could lose its tax-favored status resulting in tax liability for the employees and employer.

The following list details what a written plan document should include:

• A specific description of each of the benefits provided under the plan, including the periods of coverage. Example: medical and dental insurance plans that are on a January to December plan year.
• Eligibility provisions, including a statement that a participant must be an employee.
• The plan's procedures for enrolling and changing elections, including a statement that the elections are irrevocable except in the case that the plan allows mid-year changes following certain change in status events. The document should identify which change in status elections are permitted by the plan (See section below for more information). Should also identify election periods (open enrollments, new hire periods, etc.) and the effective date of elections.
• How the plan is funded including an explanation of employer and employee contribution procedures.
• Maximum amount of employer and employee contributions.
• Identification of plan year.
• Whether the plan includes a Flexible Spending Arrangement (FSA) and its specific requirements, including the uniform coverage and use-it-or-lose-it rules. It should also include language on over-the-counter medications as eligible expenses under a health FSA.
• Whether the FSA includes a grace period, which may be up to 2 1/2 months.
• Whether the plan permits qualified rollovers from an FSA to an HSA.

When Can Employees Change Their Elections?

Participants in a cafeteria plan must be given the opportunity at least annually to make or change elections. This is typically during an open enrollment period. However, a cafeteria plan is not required to allow mid-year changes.

At minimum, a cafeteria plan must permit certain individuals who qualify for HIPAA Special Enrollment Rights to enroll in coverage. However, the cafeteria plan may be designed that the individual must pay for the coverage on a post-tax basis outside of the cafeteria plan until the next enrollment period. For more information on Special Enrollment Rights, please see the HIPAA section of this website.

Additionally, upon the decision of the plan sponsor and provision in the plan document, a cafeteria plan may permit mid-year changes based on the following events:

• Change in status (including marital status, number of dependents, employment status, dependent ceases to satisfy eligibility requirements, change in residence, or adoption)
• Change in cost with an automatic increase or decrease to employee contributions
• Significant cost changes
• Significant curtailment in coverage (including loss of coverage, increase in co-payments, or increase in co-insurance)
• Addition or significant improvement of benefit options
• Change in coverage under other employer plan
• Loss of group health coverage through government or educational institution
• Entitlement to Medicare or Medicaid
• Leave of absence under FMLA or USERRA

If the plan receives a judgment, decree, or order requiring coverage for an employee's dependent child, such as a Qualified Medical Child Support Order (QMCSO), the plan should allow the addition of coverage. However, as with the Special Enrollment Rights, the plan may decide that the individual must pay for the coverage on a post-tax basis outside of the cafeteria plan until the next enrollment period.

The change in election must be consistent with the event and the plan may allow "tag-along" changes for existing spouses and dependent children.

FAQs

Can a 2% S-Corp shareholder participate in a cafeteria plan?

No, a 2% S-Corp shareholder is not considered an employee and would therefore not be permitted to make pre-tax contributions under a cafeteria plan. The same would apply to a sole proprietor and partners in a partnership.

Is an HSA subject to the rules regarding mid-year changes?

No, the rules regarding mid-year changes do not apply to Health Savings Accounts (HSAs). An HSA must permit participants to change elections at least monthly- even if the HSA is provided through the cafeteria plan. However, the change must be prospective.

Additional Resources

• Newly Proposed Rules on Cafeteria Plans, issued by the IRS in August 2007
• IRS Publication 15b: An overview of cafeteria plans and qualified benefits