Employers who are interested in designing different benefits packages for different categories of employees must comply with both the Internal Revenue Code and the Affordable Care Act. This blog series will examine some options that employers may consider. This first post focuses on separate cafeteria plans for separate business units.
In light of the growth of the gig economy, many employers are increasing the number of categories of their employees and associates. As the categories increase, so too has employers' interest in being able to offer different benefits packages to different categories of employees.
While there are many options for doing so, employers must navigate both the requirements of the Internal Revenue Code ("IRC") and the Affordable Care Act ("ACA") before offering different medical benefits to different types of workers. Clearly, the most conservative approach is to offer all eligible employees the same benefit options. But if you need some flexibility, employers must pay special attention to both laws.
Understanding how to comply with the IRC and the ACA in this regard requires some foundational education on the laws surrounding cafeteria plans, which apply to many plans offering medical, dental, and vision coverage as well as other flexible spending healthcare accounts generally. Section 125 of the IRC prescribes the requirements for employers who wish to permit employees to make benefit contributions (i.e., premium payments) on a pre-tax basis. Plans established and maintained in compliance with Section 125 allow employees to elect between receiving all of their pay in cash, or reducing their cash pay — and hence their taxable income — so as to receive one or more qualified employee benefits. Because Section 125 plans offer employees choices from a menu of cash or qualified benefits, they are referred to as "cafeteria" plans.
However, Section 125 requires that cafeteria plans satisfy certain nondiscrimination tests, or else highly compensated participants ("HCPs") will lose favorable tax treatment they receive under the cafeteria plan — i.e., their salary reduction for payments of premiums can be treated as taxable income.
The first nondiscrimination test pertains to eligibility. Eligibility criteria will not be considered discriminatory if: (1) no more than three years of employment is required, and the length of employment requirement is the same for all employees; (2) employees who meet the employment requirement are allowed to begin participation by the first day of the first plan year following the date they meet the requirement; and (3) the plan satisfies the nondiscriminatory classification test under IRC Section 410(b)(2)(A)(i). Section 410(b)(2)(A)(i), applicable to cafeteria plan benefits under Section 125, prohibits benefits discrimination in favor of HCPs and includes an assessment of whether the classification is reasonable and established under objective business criteria. The second nondiscrimination test also pertains to benefits. It prohibits contributions and benefits under a cafeteria plan to discriminate in favor of HCPs, their spouses, or dependents.
Because of the risk that a cafeteria plan may fail the nondiscrimination tests above, one option employers are using is to create entirely separate cafeteria plans for separate categories of employees and associates, or separate business units. Separate plans are beneficial because they lower the risk of violating the nondiscrimination requirements of Section 125. Because different business units, or different categories or employees, can be placed into different plans, levels of benefits can diverge across the plans (rather than within a single plan) and face less risk under the IRC.
However, this option requires creation of separate plans and plan documents, with separate reporting and disclosure obligations. This can also require additional operational and administrative functions to maintain the separation of multiple plans. Because of the administrative difficulty, some large employers are hesitant to adopt this approach.
Several other options exist, and will be discussed in future posts. Stay tuned to this blog, or reach out to the authors, if you have questions about how to structure your employee benefit plan.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.