A cafeteria plan is an employer-provided written plan that offers employees the opportunity to choose between at least one permitted taxable benefit and at least one qualified employee benefit. There is no federal law that requires employers to establish cafeteria plans; however, some states require employers to have cafeteria plans for employees to pay for health insurance on a pre-tax basis.
To comply with Internal Revenue Code Section 125, a cafeteria plan must satisfy a set of structural requirements and a set of nondiscrimination rules. Violations of the structural requirements will disqualify the entire plan so that no employee obtains the favorable tax benefits under Section 125, even if the plan meets the nondiscrimination rules. Violations of the nondiscrimination rules have adverse consequences only on the group of employees in whose favor discrimination is prohibited.
A cafeteria plan must pass an eligibility test, a contributions and benefits test, and a concentration test for highly compensated individuals to receive the tax benefits of Section 125. Failure to meet these nondiscrimination requirements has no effect on non-highly compensated cafeteria plan participants.
The IRS issued proposed cafeteria plan regulations on August 6, 2007. Final regulations have not been issued. According to the proposed regulations, taxpayers may rely on the proposed regulations for guidance pending the issuance of final regulations.
The proposed cafeteria plan regulations make it clear that the plan must meet the nondiscrimination tests. Also, the plan must not discriminate in favor of highly compensated participants in its operation. For example, a plan might be considered discriminatory if adoption assistance is added to the plan when the CEO is in the process of adopting a child and adoption assistance is dropped when the adoption is final.
Be aware that Section 125 nondiscrimination rules are separate from and unrelated to Section 105(h) nondiscrimination rules. Further, Section 125 nondiscrimination rules apply to all cafeteria plans regardless of their status as fully insured, self-funded, church plan, or governmental plan.
As a practical matter, these nondiscrimination rules prohibit executive health plans offered through a cafeteria plan.
Nondiscrimination testing can help employers avoid rule violations. But there are a number of definitions of key terms used in the tests that must be understood prior to completing the tests:
Highly Compensated Individuals. Highly compensated individuals are defined as:
- Officers
- Five percent shareholders
- Highly compensated employees (HCEs)
- Spouses or dependents of any of the preceding individuals
Highly Compensated Participant. A highly compensated participant is a highly compensated individual who is eligible to participate in the cafeteria plan.
Officers. Officers include any individual who was an officer of the company for the prior plan year (or current plan year in the case of the first year of employment).
Five Percent Shareholders. Five percent shareholders include any individual who – in either the preceding plan year or current plan year – owns more than five percent of the voting power or value of all classes of stock of the employer, determined without attribution.
Highly Compensated. Highly compensated means any individual or participant who – for the prior plan year or the current plan year in the case of the first year of employment – had annual compensation from the employer in excess of the compensation amount specified in the Internal Revenue Code and, if elected by the employer, was also in the top-paid group of employees for the year. For 2016, the applicable compensation amount is $120,000.
Key Employee. A key employee is a participant who, at any time during the plan year, is one of the following:
- An officer with annual compensation greater than an indexed amount ($170,000 for 2016)
- A five percent owner of the employer
- A one percent owner having compensation in excess of $150,000
