The IRS Gives Its Final Word On Cafeteria Plan Election Changes

On January 10, 2001, the IRS issued final regulations that revise the final and proposed cafeteria plan regulations issued March 23, 2000. The 2001 regulations address all of the "changes in status" for which a cafeteria plan may permit mid-year election changes. For example, if a cafeteria plan participant has a change in marital status, employment status or dependent status that affects the participant's eligibility, then the plan may permit the participant to make a corresponding change to his or her cafeteria plan election in the middle of the plan year. The 2001 regulations also provide final guidance concerning mid-year election changes that are permitted due to changes in "cost or coverage" under a cafeteria plan.

The change in status rules apply to qualified benefits offered under a cafeteria plan, such as: accident or health plans (including health flexible spending arrangements), group term life insurance, disability coverage, dependent care assistance plans, and adoption assistance plans. The change in cost or coverage rules apply to all of these qualified benefits except health flexible spending arrangements.

The "final" regulations issued in March 2000 remain applicable for plan years beginning in 2001. Most of the changes that the 2001 regulations make to the March 2000 final regulations also apply for plan years beginning in 2001. If you are not familiar with the March 2000 regulations, you may contact someone in Davis Wright Tremaine LLP's employee benefits section for a copy of our annual seminar materials on this subject.

If you are familiar with the March 2000 final regulations, you may be curious how the 2001 regulations change the March 2000 final regulations. Fortunately, the handful of changes to the March 2000 final regulations are generally clarifications, so nearly all of the March 2000 regulations remain intact.

The 2001 regulations make the following clarifications and changes to the March 2000 final regulations:

• with respect to special enrollment rights under HIPAA, a participant who marries mid-year may make a prospective election change but may not change his or her election retroactive to the date of marriage;
• a change in status that affects eligibility includes a change in status that results in an increase in the number of a participant's family members or dependents;
• group term life or disability coverage elections may be changed mid-year due to any change in status event;
• if a participant moves out of an HMO service area, the participant may drop coverage but may not change his or her health flexible spending account election because the participant's eligibility under the health flexible spending account has not been affected;
• an employer can rely on an employee's certification that the employee has or will obtain coverage under a spouse or dependent's plan unless the employer has reason to believe the certification is incorrect; and
• a participant may cancel accident or health coverage for a child according to a judgment, decree or order requiring that the employee's spouse, former spouse or other individual provide coverage for the child only if this other coverage is actually procured for the child (this change is applicable for plan years beginning in 2002).

To the extent the 2001 final regulations adopt and revise the March 2000 proposed regulations, they are not effective until plan years beginning in 2002. Your company may elect to rely on these provisions of the final regulations earlier, if you inform participants and revise your plan documents accordingly.

The 2001 regulations adopt the March 2000 proposed regulations in that they extend the change in status rules to allow mid-year election changes to dependent care assistance plans and adoption assistance plans. The 2001 regulations also adopt the position in the March 2000 proposed regulations that health flexible spending accounts are excluded from the cost or coverage rules.

The 2001 regulations make numerous changes to the cost or coverage rules addressed in the March 2000 proposed regulations. The following examples illustrate some of the key aspects of the new cost or coverage rules:

ABC Company has a cafeteria plan (the "ABC Cafeteria Plan") that offers medical benefits through Healthco Indemnity. ABC Cafeteria Plan participants pay a portion of the Healthco medical premiums through salary reduction. In the middle of the 2001 plan year, Healthco premiums are increased significantly. Under the 2001 regulations, ABC Company may automatically increase employee salary reductions to cover the increased premiums (as long as automatic adjustments are provided for in the ABC Cafeteria Plan). Alternatively, the ABC Cafeteria Plan may permit participants either to revoke their coverage and elect similar coverage provided under the ABC Cafeteria Plan (such as an HMO option) or to drop coverage if no similar coverage is available.

Now assume that, instead of increasing premiums, ABC Company cancels its contract with Healthco mid-year, resulting in elimination of the indemnity option from the ABC Cafeteria Plan menu. This is unquestionably a loss of coverage under the 2001 regulations, and the ABC Cafeteria Plan may permit participants either to elect similar coverage provided under the ABC Cafeteria Plan (such as an HMO option) or to drop coverage if no similar coverage is available.

Now assume that ABC Company does not cancel Healthco's contract, and that instead of a premium increase, Healthco's deductibles significantly increase mid-year. This is considered a significant curtailment of coverage, but it is not a loss of coverage. As a result, the ABC Cafeteria Plan may permit participants to revoke their coverage and elect similar coverage provided under the ABC Cafeteria Plan (such as an HMO option). However, the ABC Cafeteria Plan may not permit participants to drop coverage, even if no similar coverage is available! Unfortunately, the ABC Cafeteria Plan must also reject a participant's request to soften the blow by decreasing contributions to his health flexible spending account, because mid-year changes to health flexible spending accounts cannot be made on account of changes in cost or coverage.

The 2001 regulations address several other changes in cost or coverage that a cafeteria plan may recognize as permitting a mid-year election change, such as: decreases in cost; the addition of new or better benefit package options; and changes in cost or coverage under the participant's spouse's or dependent's cafeteria plan. The 2001 regulations also provide guidance as to when a participant may change the amount of his or her contributions to a dependent care assistance plans due to mid-year changes in dependent care costs or coverage.

ACTION NEEDED: In most cases, the 2001 regulations provide greater flexibility by expanding the list of election changes that participants may make. However, your company must ensure that your cafeteria plan is not permitting election changes more frequently than the regulations allow. Also, your cafeteria plan may, but is not required to, permit every election change listed in the regulations. Participants must be informed of changes to your company's cafeteria plan and plan documents must revised as of the effective dates discussed in this article.

Additionally, as noted earlier, to the extent the 2001 final regulations adopt and revise the March 2000 proposed regulations, they are not effective until plan years beginning in 2002. If your company wishes to rely on these provisions of the final regulations earlier, it may do so if you inform participants and revise your plan documents accordingly.