The Internal Revenue Service has released proposed regulations for plans covered under Section 125 of the Internal Revenue Code, also known as cafeteria plans. These proposed cafeteria plan regulations are scheduled to go into effect beginning on or after January 1, 2009. Employers may currently rely upon the proposed regulations in drafting and interpreting cafeteria plans.

Highlights of the new regulations include:

1. Written plan document: Cafeteria plans must have a written plan document that includes a description of (i) benefits offered through the plan, (ii) rules governing participation, elections and contributions, (iii) special rules applicable to health and dependent care flexible spending accounts (FSAs), and (iv) rules governing contributions and distributions from health savings accounts. No plan documents or amendments can be effective retroactively.

2. Permissible benefits: Cafeteria plans may only offer a choice between certain taxable benefits (cash compensation or certain items that are treated as cash compensation) or qualified benefits, which include accident and health benefits, health and dependent care FSAs, adoption assistance, COBRA premiums, long-term and short-term disability coverage, group-term life insurance for employees (but not for spouses or dependents) and accidental death and dismemberment insurance, and 401(k) deferrals. Generally, deferred compensation is not allowed under cafeteria plans, except in cases relating to the qualified benefits described above.

3. Nondiscrimination: Three nondiscrimination tests apply to cafeteria plans: an eligibility test, a contributions and benefits test, and a key employee test. The proposed regulations provide guidance regarding the tests that is similar to the nondiscrimination rules applicable to qualified retirement plans. The proposed regulations also provide a safe harbor from nondiscrimination testing for premium-only plans and rules regarding aggregation of multiple cafeteria plans when testing. No corrective procedure is currently available if the tests are not passed.

4. Employees only: Only employees may participate in a cafeteria plan. Generally, self-employed individuals, partners, LLC members, 2% shareholders in S corporations, and directors serving on a corporate board may not participate. There are certain dual-status individuals who, by providing services both as an employee and as a contractor or director, are permitted to participate with respect to their compensation as an employee.

5. Other items: The proposed regulations also provide new guidance on domestic-partner coverage, automatic elections, retroactive enrollment for new employees, tax treatment of group-term life insurance, substantiation of claims, the use of debit cards, and the treatment of forfeitures from FSAs.

With the withdrawal of all prior cafeteria plan guidance, the proposed regulations now constitute the primary regulatory guidance on the administration of cafeteria plans. Failure to meet documentary and operational compliance rules could lead to plan disqualification, resulting in taxable income to participants of the value of the taxable benefit with the greatest value that an employee could have elected to receive. Employers should consider reviewing their cafeteria plans for both documentary and operational compliance.