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Preamble to Proposed Regulations for Section 1.125

Tax Treatment of Cafeteria Plans Internal Revenue Service



AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Preamble, 65 Fed. Reg. 15587 March 23rd, 2000: Partial withdrawal of notice of proposed rulemaking; amendment to notice of proposed rulemaking; and notice of proposed rulemaking.

SUMMARY: This document withdraws portions of the notice of proposed rulemaking published in the Federal Register on March 7, 1989 and amends proposed regulations under section 125. These proposed regulations clarify the circumstances under which a section 125 cafeteria plan election may be changed. The proposed regulations permit an employer to allow a section 125 cafeteria plan participant to revoke an existing election and make a new election during a period of coverage for accident or health coverage, group-term life insurance coverage, dependent care assistance, and adoption assistance.

DATES: Written and electronic comments and requests for a public hearing must be received by June 21, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R (REG-117162-99), room 5226, Internal Revenue Service, POB 7604, Ben Franklin Station, Washington, DC 20044. Submissions may be hand delivered between the hours of 8 am and 5 pm to: CC:DOM:CORP:R (REG-117162-99), Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue NW., Washington, DC. Alternatively, taxpayers may submit comments electronically via the internet by selecting the ``Tax Regs'' option on the IRS Home Page, or by submitting comments directly to the IRS internet site at http://www.irs.gov.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Janet A. Laufer or Christine L. Keller at (202) 622-6080; concerning submissions or to request a public hearing, LaNita Van Dyke at (202) 622-7180. These are not toll-free numbers.

SUPPLEMENTARY INFORMATION:

Background

Section 125 \1\ permits an employer to offer employees the choice between taxable income and certain nontaxable or ``qualified benefits'' \2\ through a cafeteria plan, without the employees having to recognize the taxable income. In 1984 and 1989, proposed regulations were published relating to the administration of cafeteria plans.\3\ In general, the 1984 and 1989 proposed regulations require that for benefits to be provided on a pre-tax basis under section 125, an employee may make changes during a plan year only in certain circumstances.\4\ Specifically, Secs. 1.125-1, Q&A-8 and 1.125-2, Q&A-6(b), (c) and (d) permit participants to make benefit election changes during a plan year pursuant to changes in cost or coverage, changes in family status, and separation from service

In 1997, temporary and proposed regulations were issued addressing the standards under which a cafeteria plan may permit a participant to change his or her group health coverage election during a period of coverage to conform with the special enrollment rights under section 9801(f) (added to the Internal Revenue Code by the Health Insurance Portability and Accountability Act of 1996 (HIPAA)) and to change his or her group health or group-term life insurance coverage in a variety of change in status situations. \5\ The 1997 regulations are being published as final regulations elsewhere in this issue of the Federal Register.

Explanation of Provisions

A. Summary

The proposed regulations being published in this notice of proposed rulemaking were developed as part of an integrated package with the final regulations that are being published at the same time. These proposed regulations supplement the final regulations by permitting a mid-year cafeteria plan election change in connection with dependent care assistance and adoption assistance under change in status standards that are the same as the standards in the final regulations for accident or health plans and for group-term life insurance, and by adding change in status standards that are specific to dependent care and adoption assistance. These proposed regulations also refine and expand upon the approach adopted in the 1989 proposed regulations (at Sec. 1.125-2, Q&A-6(b)) by providing that a cafeteria plan may permit employees to make mid-year election changes with respect to group-term life insurance, dependent care assistance, and adoption assistance as well as accident or health coverage, on account of changes in cost or coverage. This expansion of the cost or coverage rules would also allow employees to make election changes if, during a period of coverage, (1) a new benefit package option is offered, or a benefit package option is eliminated, under the plan or (2) a coverage change is made under a plan of the employer of an employee's spouse or dependent. These proposed regulations include a variety of examples illustrating how the rules apply in specific situations.

B. Change in Status

The proposed regulations published in this notice of proposed rulemaking complement the final regulations being published elsewhere in this issue of the Federal Register with respect to special enrollment rights and changes in status for accident or health coverage and group-term life insurance coverage. These proposed regulations take into account comments received on the 1997 temporary and proposed regulations, including comments suggesting the desirability of uniformity in the rules for different types of qualified benefits to the extent appropriate given the nature of the benefits. In response to comments, the new proposed regulations address circumstances under which a cafeteria plan may permit an employee to change an election for dependent care assistance under section 129 and adoption assistance under section 137 during a plan year. The proposed change in status rules for dependent care assistance and adoption assistance parallel the change in status rules for accident or health coverage and group-term life insurance coverage contained in the final regulations, with some additional rules specific to dependent care and adoption assistance. For example, while a change in the number of dependents is a status change for other types of qualified benefits, a change in the number of qualifying individuals, as defined in section 21(b)(1), is a change in status for purposes of dependent care assistance. Likewise, these proposed regulations allow an additional change in status event for adoption assistance (the commencement or termination of an adoption proceeding). The consistency rule in the proposed regulations is the same as the consistency rule in the final regulations, with certain provisions that are specific to dependent care and adoption assistance changes.\6\

C. Change in Cost or Coverage

The new proposed regulations also address election changes to reflect significant cost and coverage changes for all types of qualified benefits provided under a cafeteria plan. The new proposed regulations refine and expand upon the approach taken in the 1989 proposed regulations at Sec. 1.125-2, Q&A-6 with respect to changes in cost or coverage under the plan. For example, in response to comments, the new proposed regulations provide that if a plan adds a new benefit package option (such as a new HMO option), the cafeteria plan may permit affected participants to elect that option and make a corresponding election change with respect to other benefit package options during a period of coverage.

The new proposed regulations also generally extend the cost or coverage rules under Sec. 1.125-2, Q&A-6(b) to permit election changes for self-insured accident or health plans, group-term life insurance, dependent care assistance and adoption assistance coverage under a cafeteria plan. Thus, for example, if the cost of a self-insured accident or health plan increases, a plan may automatically make a corresponding change in the salary reduction charge. In addition, the new proposed regulations treat a change of dependent care provider as similar to the addition of a new HMO option under an accident or health plan, with the result that a corresponding election change can be made when one dependent care provider is replaced by another. While the coverage change rules apply to dependent care regardless of whether the dependent care provider is related to the employee, the cost change rules do not apply to dependent care if the dependent care provider is a relative of the employee making the election.

Commentators on the 1997 temporary and proposed regulations also raised a concern that when the plan of the employer of a spouse conducts annual open enrollment for group health benefits beginning at a different time of the year than the annual open enrollment for group health benefits offered by the employee's employer, the employee is unnecessarily restricted from making election changes that correspond with elections made by the employee's spouse. These commentators suggested that if one spouse makes an election change during an open enrollment period, a corresponding change should be permitted for the other spouse. In response to these comments, the new proposed regulations provide that a cafeteria plan may permit an employee to make an election change, during a period of coverage, corresponding with an open enrollment period change made by a spouse or dependent when the plan of that individual's employer has a different period of coverage.

In addition, the new proposed regulations provide that a cafeteria plan may permit an employee to make an election change in the event that a spouse or dependent makes an election change under a cafeteria plan (or qualified benefits plan) maintained by that individual's employer, provided that the spouse or dependent's election change satisfies the election change rules under the proposed regulation. For example, under this provision, if the plan of a spouse's employer adds a new HMO option to its group health plan, and the spouse elects to enroll the family in that new option, a cafeteria plan may permit the employee to drop family coverage. These new rules apply only if the change made by the employee is on account of and corresponds with the change made under the other employer's plan. This expansion of the existing cost or coverage change rules permits employees to make election changes to ensure consistent coverage of family members and eliminate duplicate coverage.

The cost or coverage rules in the new proposed regulations have not been extended to health flexible spending arrangements. This ensures that those arrangements will not permit election changes in a manner that is inconsistent with the requirement, under Secs. 1.125-1, Q&A-17 and 1.125-2, Q&A-7 of the existing proposed regulations, that such arrangements exhibit the risk-shifting and risk-distribution characteristics of insurance.

Although the final regulations being published elsewhere in this issue of the Federal Register permit election changes in the event an individual becomes eligible (or loses eligibility) for Medicare or Medicaid, these proposed regulations do not address election changes to reflect an individual's eligibility for other government programs that pay for or subsidize health coverage.\7\ For example, the new rules do not address the possibility that an employee's child may cease to be eligible for coverage under a state's children's health insurance program (CHIP) designed in accordance with Title XXI of the Social Security Act.\8\ Comments are requested on whether eligibility or ineligibility for such a government program should be added to the types of events that allow a cafeteria plan election change (including any special administrative difficulties that employers might have in identifying this type of event) and, if so, the types of government programs that should be permitted to be taken into account.

D. Effective Date and Reliance

The new proposed regulations do not specify a proposed effective date. Any effective date will be prospective, and comments are requested on the extent of lead time necessary for employers to be able to implement the new proposed regulations after they are adopted as final regulations.

Until the effective date of further guidance, taxpayers may rely on the new proposed regulations. In addition, until the effective date of further guidance, taxpayers may continue to rely on the change in family status rules in the existing proposed regulations (at Sec. 1.125-2, Q&A-6(c)) with respect to benefits other than accident and health coverage and group-term life insurance coverage, and on the cost or coverage change rules in the existing proposed regulations (at Sec. 1.125-2, Q&A-6(b)) with respect to all types of qualified benefits.

Special Analyses

It has been determined that this notice of proposed rulemaking is not a significant regulatory action as defined in Executive Order 12866. Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) do not apply to these regulations, and because the regulations do not impose a collection of information on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, these proposed regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations, consideration will be given to any written and electronic comments (a signed original and eight (8) copies) that are submitted timely to the IRS. The IRS and Treasury specifically request comments on the clarity of the proposed regulations and how they may be made easier to understand. All comments will be available for public inspection and copying. A public hearing will be scheduled if requested in writing by any person that timely submits written comments. If a public hearing is scheduled, notice of the date, time, and place for the hearing will be published in the Federal Register.

Drafting Information:

The principal authors of these proposed regulations are Janet A. Laufer and Christine L. Keller, Office of the Associate Chief Counsel (Employee Benefits and Exempt Organizations). However, other personnel from the IRS and Treasury Department participated in their development.

Footnotes

\0\ Federal Register: March 23, 2000 (Volume 65, Number 57) Proposed Rules; Page 15587-15592; From the Federal Register Online via GPO Access [wais.access.gpo.gov][DOCID:fr23mr00-25]

\1\ Revenue Act of 1978, Public Law 95-600 (November 6, 1978): Sen. Rep. 95-1263, 95th Cong., 2d Sess., 74-78, 186-187 (October 1, 1978); H.R. Rep. No. 95-1445, 95th Cong. 2d Sess., 63-66 (August 4, 1978); H.R. Rep. No. 95-250, 96th Cong., 2d Sess., 206-207, 253-254 (October 15, 1978).

\2\ "Qualified benefits"' are generally any benefits excluded from income, including coverage under an employer-provided accident or health plan under sections 105 and 106; group-term life insurance under section 79; elective contributions under a qualified cash or deferred arrangement within the meaning of section 401(k); dependent care assistance under section 129; and adoption assistance under section 137. The following are not qualified benefits: products advertised, marketed, or offered as long-term care insurance; medical savings accounts under section 106(b); qualified scholarships under section 117; educational assistance programs under section 127; and fringe benefits under section 132. Qualified benefits can be provided under a cafeteria plan either through insured arrangements or arrangements that are not insured.

\3\ 49 FR 19321 (May 7, 1984) and 54 FR 9460 (March 7, 1989), respectively.

\4\ Those proposed regulations contain special rules with respect to flexible spending arrangements. A flexible spending arrangement (FSA) is defined in section 106(c)(2). Under section 106(c)(2), and FSA is generally a benefit program under which the maximum reimbursement reasonably available for coverage is less than 500% of the value of the coverage.

\5\ 62 FR 60196 (November 7, 1997) and 62 FR 60165 (November 7, 1997), respectively. IRS announcement 98-105 (1998-49 I.R.B. 21 (November 23, 1998)) states that the Service will amend the effective date of these temporary regulations (Sec. 1.125-4T) and proposed regulations (Sec. 1.125-4) so that they will not be effective before plan years beginning at least 120 days after further guidance is issued.

\6\ Conforming changes have also been made to Q&A-8 of the 1984 proposed regulations under Sec. 1.125-1

\7\ The loss of coverage under a government program may give rise to a special enrollment right under section 9801(f) and, thus, the issue addressed here is relevant only in cases in which the special enrollment rules do not apply.

\8\ Added to the Social Security Act by section 4901 of the Balanced Budget Act of 1997, Public Law 105-33 (August 5, 1997).