Cafeteria Plan Benefits

1. What is a cafeteria plan?

A cafeteria plan is a benefit plan maintained by an employer under which all participants are employees and each participant has the opportunity to select the particular benefits desired. The plan must offer at least one nontaxable benefit (e.g., accident or health insurance coverage) and at least one taxable benefit (e.g., cash). Treasury regulations require that the cafeteria plan be a written plan formally adopted prior to the first pre-tax salary reduction (Reg. Sec. 1.125-1 Q&A-2).

2. How does a cafeteria plan work?

Participating employees choose to redirect a portion of their salary from taxable cash compensation to nontaxable fringe benefits such as accident or health insurance coverage. They choose only those benefits they desire and pay for them by pre-tax or after-tax salary reduction.

3. Who can participate?

Participants in the cafeteria plan must be employees of the sponsoring employer or an affiliated employer. Self-employed individuals, including partners, 2% shareholders in S corporations, and sole proprietors are not considered to be employees for this purpose. A spouse or dependent beneficiary of an employee may benefit from the plan as a dependent under an employee/participant's coverage, but may not otherwise select benefits or make contributions.

4. What benefits may be offered through a cafeteria plan?

There are basically 2 categories of "qualified benefits" that may be offered through a cafeteria plan - nontaxable benefits that may be purchased with pre-tax dollars and certain taxable benefits that may only be purchased with after-tax dollars.

5. What nontaxable benefits may be offered through a cafeteria plan?

The nontaxable benefits that may be offered through a cafeteria plan include: up to $50,000 group term life insurance on an employee, nondiscriminatory health plan coverage (such as major medical and hospitalization insurance, dental insurance, cancer insurance, hospital indemnity and intensive care unit insurance, vision or hearing insurance, and uninsured Medical Reimbursement), accidental-death and -dismemberment plans, disability insurance (long-term and short-term), and certain other nontaxable benefit plans that are excluded from income under specific tax code provisions (such as Dependent Care Reimbursement, group legal services, or a 401(k) cash or deferred arrangement).

6. What taxable benefits may be offered through a cafeteria plan?

Taxable benefits that may be offered through a cafeteria plan generally include cash and any other benefit treated like cash (for tax withholding and reporting purposes) that does not result in a deferral of compensation (Question 10).

7. What must the written cafeteria Plan Document contain?

This written document must contain at least the following information:

• a description of each benefit available and the period during which the benefit is provided,

• the plan's eligibility rules,

• the procedures governing participants' elections,

• the manner in which employer contributions are made,

• the maximum amount of employer contributions available, 

• and the plan year.

The Plan Document may include, by reference, benefits established under other separate written plans such as insurance policies and/or flexible spending plans (Reg. Sec. 1.125-1 Q&A-3).

8. Can pre-tax contributions to a cafeteria plan be made pursuant to employee Salary Reduction Agreements?

Yes. A Plan Document may permit participants to elect to reduce their compensation (or forego increases in compensation) and have these amounts contributed by the employer on their behalf (Reg. Sec. 1.125-1 Q&A-6).

9. Can a cafeteria plan offer deferred compensation?

No. Except for contributions to a qualified 401(k) plan, a cafeteria plan cannot offer any benefit that defers compensation. Thus, pension, retirement and insurance plans with a savings or investment feature cannot be included as benefits in a cafeteria plan (Question 14).

10. When would a cafeteria plan benefit be considered to be deferred compensation?

A cafeteria plan will result in a deferral of compensation if the plan allows participants to use contributions from one plan year to purchase a benefit that will be provided in a subsequent year. Similarly, a plan that permits employees to carry over unused elective contributions or plan benefits from one plan year to another plan year is considered a deferral of compensation (Reg. Sec. 1.125-2 Q&A-5).

11. Does Section 125 affect whether pre-existing benefits are taxable or nontaxable?

No. A benefit that is nontaxable under the Internal Revenue Code when paid for by the employer continues to be nontaxable under a cafeteria plan. Likewise, any employer-funded benefit that is taxable under the Internal Revenue Code continues to be taxable when offered under a cafeteria plan. It should be noted, however, that failure to satisfy the Section 125 nondiscrimination requirements (see Section 6 of this manual) could cause benefits to become taxable. In addition, certain benefits (such as disability benefits) will be taxable whether or not the plan passes discrimination testing (Reg. Sec. 1.125-1 Q&A 16).

12. Can an employee purchase coverage under a cafeteria plan on an other-than- plan year basis?

No. The period of coverage must be 12 months. However, the cafeteria plan's initial plan year can be less than 12 months. Short plan years may occur for reasons other than the initial year, including general business reasons such as to align the plan with the employer's fiscal year or the calendar year. However, the IRS has indicated that it does not approve of consecutive short plan years under any circumstance. Note that actual payment for coverage under a cafeteria plan is made using regular payroll deductions (Reg. Sec. 1.125-1 Q&A-17).

13. What is the income tax effect of paying disability premiums through a cafeteria plan?

This will cause the disability coverage to be treated as an employer-provided disability plan (the benefits will be taxable to the employee). In addition, the employer must pay FICA taxes on disability benefits paid during the first 6 months after the month of an employee's disability.

14. Can a participant pay for whole life insurance or universal life insurance premiums through a cafeteria plan?

No. Life insurance plans with a savings or investment feature, such as whole or universal life, are not permissible qualified benefits under a cafeteria plan (Reg. Sec. 1.125-2 Q&A-5).

15. Can a sole proprietorship, partnership, or S corporation sponsor a cafeteria plan?

Yes. These entities can sponsor a cafeteria plan and save FICA taxes on money put into the plan. However, the proprietor, partner or greater than 2% shareholder in an S corporation cannot participate in the cafeteria plan (see also Question 31).

16. Must a cafeteria plan be based on a calendar year?

No. Nothing in the code or regulations requires that a cafeteria plan be maintained on a calendar-year basis. Generally, if the only benefit provided through a cafeteria plan is group medical insurance, the cafeteria plan should coincide with the medical benefit plan year in order to coordinate open enrollments under both plans. On the other hand, if the cafeteria plan has dependent care or unreimbursed medical expense reimbursement benefits, a calendar year may be more appropriate. This is because participants tend to project reimbursement type benefits on a calendar-year basis.

17. Are the "proposed" cafeteria plan regulations currently in effect?

Yes. The Proposed Regulations are effective for plan years beginning after December 31, 1988. Thus, the IRS will apply these Proposed Regulations when examining returns with respect to taxpayers and plans. The Proposed Regulations also indicate that taxpayers may rely on them for guidance pending the issuance of final regulations. If future regulations are more restrictive than the current Proposed Regulations, the future regulations will not be retroactive.

18. Are cafeteria plan benefits limited to "group" policies, or can a cafeteria plan be used to pay premiums for individual insurance policies?

The Proposed Regulations provide that Code Section 106 accident and health policies may be provided in a cafeteria plan. The Code Section 106 Regulations specifically contemplate individual policies. The IRS has also verbally confirmed that individual policy premiums can be paid using a cafeteria plan. Therefore, individual health and accident policies can be purchased on a salary reduction basis through the ordinary operation of a cafeteria plan (i.e., subject to the irrevocable election requirements described below) (Reg. Sec. 1.125-2 Q&A-7).

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