United States: Mid-Year Elections Under IRS Cafeteria Plans Final And Proposed Regulations

The Internal Revenue Service ("IRS") has issued Final Regulations with respect to "Permitted Election Changes" for the life, health and disability qualified benefits offered under a Cafeteria Plan (the "Final Regulations"). Since many employee contributions receive pre-tax treatment under Section 125 of the Internal Revenue Code (the "Code"), the opportunity for employees to change their benefit selection based on personal or uncontrollable events is crucial to maximizing an employee’s benefits under such plans at a relatively low cost to employer plan sponsors.

At the same time, the IRS has issued Proposed Regulations on two other qualified benefits (dependent care and adoption assistance), together with first-time guidance on mid-year elections based upon significant changes in cost or coverage (the "New Proposed Regulations" or "NPR"). Although a cafeteria plan is not required to offer mid-year elections, to the extent that it does so, and most plans do, such elections must be provided in the written document required by the Code and comply with the requirements of the Final and Proposed Regulations.

Effective Dates

The Final Regulations are effective for plan years beginning on or after January 1, 2001. However, plan administrators may rely on the final Regulations as of the date of their publication, March 23, 2000, and on the NPR until the effective date of further guidance. Since many cafeteria plans are administered on a calendar year basis and enrollments usually occur in the preceding 1 to 2 months prior to January 1st, it is recommended that employers consider adoption of the Regulations at this time in order to permit appropriate disclosure under the Employee Retirement Income Security Act of 1974 ("ERISA"). Informally, the IRS has stated it intends to finalize the Proposed Regulations (at least for cost of coverage changes) prior to the end of this year. Ideally, these amendments should now be incorporated into the employees’ 2001 enrollment package to satisfy ERISA disclosure requirements. The alternative (waiting for final regulations) would appear to create unnecessary administrative duplication if notices of mid-year elections are issued separate from the enrollment package.

This Alert will discuss the changes in the mid-year election requirements in both sets of regulations. Reliance on the NPRs is recommended since it is unlikely that there will be significant changes to Final Regulations, although some additional "clarifications" may be forthcoming, and operational compliance on January 1, 2001 will be facilitated by an early adoption of the mid-year provisions. The importance of mid-year elections cannot be under emphasized since failure to satisfy the written plan document requirement could result in a denial of pre-tax benefits for all participating employees in the event of an IRS audit of the employer and/or its cafeteria plan.

The Final Regulations permit a revocation of an enrollment election and a new election only if (1) a "Change In Status" event occurs and (2) the participant’s requested election change is "consistent" with that event.

In contrast to previously proposed regulations, the first significant change in the Final Regulations is that the IRS has broadened and redefined events which permit an election change beyond "family" events to employment and related events in forming the new triggering definition, redesignated as the "Change In Status Event". The NPRs also add a sixth event - adoption assistance. The following events are Change In Status Events for purposes of the Final Regulations:

1. Legal Marital Status. Events that change a participant’s legal marital status, including marriage, death of a spouse, divorce, legal separation and annulment;
2. Number of Dependents. Events that change a participant’s number of dependents, including birth, adoption, placement for adoption, or death of a dependent.
3. Employment Status. Events include termination or commencement of employment by the employee, spouse, or dependent(s); a strike or lock-out; a commencement of or return from an unpaid leave of absence; and a change in worksite. In addition, if eligibility is conditioned upon an individual’s employment status and, as a result, that status changes, then that individual becomes (or ceases to be) eligible, such change qualifies as a change in employment status (e.g. "salaried" to "union").
4. Dependent Satisfies or Ceases to Satisfy the Requirements for Unmarried Dependents. An event that causes a participant’s dependent to satisfy or cease to satisfy the requirements for coverage due to attainment of a maximum age limit, loss of student status, or any similar circumstances as provided in the plan under which the employee receives coverage; and
5. Residence. A change in place of residence of the employee, spouse, or dependent(s), but only when it affects the individual’s eligibility for coverage, such as movement out of an HMO’s area of coverage.

At first blush, the definition appears to have broadened the events which would allow a mid-year revocation and/or election by specifying additional events and providing an extension to dependents for most events. However, the Final Regulations provide an exclusive list, rather than the open-ended examples in pre-1997 proposed regulations. Additional IRS "clarification" of the events may be necessary to determine whether there is sufficient flexibility within each of the Change In Status Events. Witnesses at an August 17th public hearing requesting comments on the proposed regulations have generally urged the IRS to retreat from the exhaustive list approach and acknowledge that the list is only illustrative since there may be common sense circumstances not anticipated in the Final Regulations which arise from today’s complex family structure and work environment.

The Final Regulations do not specifically address when a bona fide "termination of employment" occurs. But the Preamble to the Final Regulations (the "Preamble") notes that an example retained from the 1997 Temporary Regulations provides a practical safe harbor that may be applied without regard to other facts and circumstances. Under this example, if an employee terminates and resumes employment within 30 days, a cafeteria plan may provide (by its terms) that the employee’s election is automatically reinstated upon his or her resumption of employment (with the same election amount for FSA coverage). The employer is not required to determine whether a bona fide Change In Status Event has occurred with respect to the termination of employment. On the other hand, a cafeteria plan also may permit an employee who resumes employment more than 30 days following termination to be reinstated to the prior election or to make a new election. In the alternative, the Plan may prohibit any coverage for the balance of the Plan Year.

Another consideration is that the Final Regulations do not contain any prescribed period of time within which mid-year election changes must be made. But the IRS has cautioned that a mid-year election change cannot be made so long after the event permitting the change that the election is not "on account of" the event, without violating the consistency requirement, which is described in detail below. The Preamble also states that a cafeteria plan may require that any election change must be made within a specified period after a Change In Status Event. This requirement would not apply to elections in connection with rights for which there are specific minimum election periods, such as "special enrollment rules" under Code Sec. 9801 (as added by HIPAA) and Code Sec. 4980B (relating to COBRA coverage). For ease of administration, employers should condition the election on the same 30 day period required under HIPAA. The IRS has also cautioned against retroactive elections for non-HIPAA reasons (e.g. a new hire cannot be given a 30 day window to enroll).

The second significant change in the Final Regulations concerns the consistency requirement, as applied to group-term life and disability income insurance coverage. The IRS has retreated from its complex position under 1997 Temporary Regulations where different rules applied for health coverage. However, the Final Regulations still require that an election change may only be permitted if it affects eligibility.

The Final Regulations clarify (and limit) the election changes that will qualify under this requirement. Generally, to be consistent, a requested election change must "be on account of and correspond with" a Change In Status Event that affects the eligibility of an employee, spouse, or dependent(s) for a qualified benefit.

This general consistency requirement is not always the end of the analysis. Unless the benefit at issue is group term life or long-term disability coverage (which necessitate a "special exception" discussed below), any other requested election change requires the following 2-step analysis:

1. Does the change satisfy the general consistency requirement? Generally, if the Change In Status Event affects eligibility for a particular coverage, a corresponding change can be made to the same type of coverage. For example, if dental coverage is affected by the event, then dental coverage can be added or dropped, but changes cannot be made to vision or disability coverage. In contrast, coverage for "health" flexible spending accounts ("FSAs") can be changed whenever an event affects any type of health coverage (e.g. dental, medical, vision or any other type of health coverage).

The Final Regulations do not specifically address what changes may be allowed if a new dependent is acquired. However, a regulatory example appears to imply that "existing" dependents can be added whenever any one dependent gains eligibility as a result of a Change In Status Event. IRS officials have informally confirmed that this "tag along" rule was intended, i.e. adding family members to coverage would be "consistent" with an event resulting in a newly eligible dependent even if other family members were previously eligible. Accordingly, an employee who gains a new spouse can elect family coverage even where "employee-plus-spouse" coverage is available.

2. Does the change satisfy any specific consistency requirement that might apply? The Final Regulations set forth the following two specific consistency tests:

• Loss of Dependent Eligibility. When the Change In Status Event is the employee’s divorce, annulment, legal separation from a spouse, the death of the spouse, dependent, or a dependent’s loss of dependency status, the employee may cancel disability or health coverage only for the spouse or dependent, as applicable, but not for anyone else.
• Specific consistency rule for gain of coverage eligibility under another employer’s plan. When such an event occurs due to a change in marital status or employment status, the employee may elect to stop or decrease coverage for that individual only if the individual actually becomes covered (or increases coverage) under the other employer’s plan. Unless the plan administrator has reason to believe that the employee is not telling the truth, IRS officials have informally indicated it is sufficient substantiation to have the employee certify to the plan administrator that the employee became covered under the plan, either by written form or using a voice response system (provided there is some form of documentation, such as a tape backup).

The exception to the general consistency requirement, in effect, would appear to constitute a third "special consistency rule" - for life or disability coverage. Thus, when there is a change in the employee’s marital status or in the employment status of the employee’s spouse or dependents, the employee may elect to increase or decrease group term life or disability insurance coverage. Either election will be deemed to correspond with the Change In Status Event and therefore satisfy the consistency requirement even if the election does not track the increase or decrease in family size, or result in a gain or loss of eligibility. However, the Final Regulations would not allow an increase or decrease upon the birth of an additional child because it doesn’t affect eligibility and fails to satisfy the broadened special consistency rule since it is not a change in employment or marital status. IRS officials have informally stated that an election change increase should be permissible under these circumstances.

In addition to the Change in Status Events rules, the Final Regulations continue the 1997 Proposed Regulation rules with respect to the three other "events" which permit mid-year elections. The first permits a cafeteria plan to comply with a child support order due to a divorce, legal separation, annulment, or change in legal custody. This event may result in coverage or the cancellation of coverage.

The second event concerns a loss of Medicare or Medicaid entitlement by an employee (or by the employee’s spouse, or their dependent(s)). The Final Regulations confirm that a cafeteria plan may permit the employee to add health coverage under the employer’s accident or health plan. Also, the plan may permit cancellation or reduction in coverage if any employee [or the employee’s spouse, or dependent(s)] who is enrolled in an accident or health plan becomes entitled to Medicare or Medicaid. Finally, mid-year elections may be made to comply with continuation of coverage under the Family and Medical Leave Act, which permits payment for such coverage on a pre- or post tax basis. Unrelated proposed regulations on FSA requirements under Cafeteria Plans are also being targeted for finalization prior to the end of the year.

Qualified Benefits. The New Proposed Regulations supplement the Final Regulations by providing additional guidance for dependent care assistance and adoption assistance which parallels the "Change In Status" rules 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" (under Code Sec. 21(b)(1), including certain dependents under age 13, and a spouse, or dependent(s) who are physically or mentally incapable of caring for themselves) is a Change In Status Event for purposes of dependent care assistance. Informal advice from IRS officials has also stated that "dependent care" FSAs may be designed to permit participants who have terminated employment to "spend down" or use up the remainder of their FSA balance to pay for post-termination expenses incurred during the rest of the plan year provided the participating employee is either looking for work or otherwise employed.

In addition, a regulatory example reflects the requirement for a cancellation of coverage for the balance of the coverage period (i.e., the plan year) after attainment of age 13, but provides no guidance for return of salary reductions exceeding work related expenses, which are apparently subject to forfeiture in accordance with pre-1997 proposed regulations. Similarly, the NPRs allow an additional Change In Status Event for adoption assistance (i.e., the commencement or termination of an adoption proceeding).

Significant Cost and Coverage Changes. The NPRs also allow certain election changes to reflect significant cost and coverage changes for all types of qualified benefits provided under a cafeteria plan. This includes health plans (both insured and self-insured), group-term life and disability insurance, dependent care and adoption assistance coverage under a cafeteria plan. Note, however, that while the cost and coverage rules in the NPRs are extended to FSAs for "dependent care", they have not been extended to "health" FSAs due to concerns with respect to the preservation of the "insurance risk" requirement (i.e., the "uniform coverage rule") for health FSAs.

Automatic Cost Changes. If the cost of a qualified plan increases (or decreases), a cafeteria plan may permit participants either to make a corresponding prospective increase (or decrease) in their elective contributions, or to revoke their elections and instead receive, on a prospective basis, coverage under another benefit package option providing similar coverage. Or the plan may, on a reasonable and consistent basis, automatically make a prospective increase (or decrease) in affected employees’ elective contributions. However, individuals who previously waived coverage will not be allowed to enroll for coverage in the event of a cost decrease.

Significant Cost Increases. If the cost of one option significantly increases, a cafeteria plan may permit a corresponding increase in payments for a benefit package option, or, the plan may permit affected participants to revoke this option and elect a corresponding election change with respect to other benefit package options, but only on a prospective basis. An example is switching from indemnity coverage to an HMO. The NPRs do not provide a definition of what is "significant", although a regulatory example indicates that a 12% cost increase is significant.

Again, IRS officials informally indicate that a coverage election may be dropped if no other coverage alternative is available. For example, employees with a single health care option may elect to drop coverage when switching from full to part-time employment.

Dependent Care FSA. When one dependent care provider is replaced by another (the only kind of cost change permitted under a dependent care FSA), a corresponding election change may be made. But the cost change rules don’t apply to dependent care if the dependent care provider is a relative of the employee making the election. In one regulatory example, a $500 increase permits a mid-year election for a dependent care FSA, and IRS officials have informally indicated that the automatic cost change rule does not apply unless the cost change is employer-initiated. Thus a provider’s increase or decrease would not permit an election charge unless the change was "significant" and qualified under the "significant cost" change rule described above. A reduction in costs as a consequence of a reduction in the provider’s hours would permit a corresponding election to decrease salary reductions.

Coverage Change. If an employer adds a new benefit option with similar coverage, affected employees can change their elections under the plan if the plan language permits such a change. Thus, individuals who had previously waived coverage would be permitted to enroll in this newly-available opportunity according to informal discussions with IRS.

If the coverage under a plan is significantly curtailed or ceases, affected employees may be permitted to revoke their election and make a prospective election for similar coverage under another benefit option. A "curtailment" occurs only if there is an overall reduction to plan participants generally. Curtailments where no alternative coverage is available will also permit coverage to be dropped. Informal guidance indicates that an employee’s doctor exiting the plan (network) is not a significant curtailment of coverage.

A coverage change also occurs when a new benefit option or coverage is added or eliminated. For dependent care FSAs, finding a new child care provider will constitute a change in coverage, similar to a "new benefit option" even where the new provider is a household employee or family member, and even if the change is from one relative to another. The same concept applies to a non-working spouse starting college on a full-time basis, thereby permitting the employee to add dependent care coverage under a flexible spending account.

Coverage Change Under Other Employer’s Plan. A participant may be permitted to make an election change during a plan year corresponding with an open enrollment period change made by a spouse, or dependent(s), when the plan of that individual’s employer has a different plan year. A participant may be permitted to make a prospective election change in the event that a spouse, or dependent(s) make an election change under a cafeteria plan or other qualified benefit plans maintained by that individual’s employer, provided the spouse’s, or dependent’s election change satisfies the Permitted Election Change "rules" of the Final Regulations. For example, if a spouse’s employer’s plan adds a new HMO option, a cafeteria plan may permit the employee to drop family coverage.

These rules apply only if the change made by the employer is on account of, and corresponds with, the change made under the other employer’s plan. Accordingly, there is no change in cost or coverage where an employer health plan permits an election to change his form of coverage (e.g., a switch to indemnity coverage from an HMO), even though there may be a premium increase, since cafeteria plan rules will not permit an election change to reflect the increased premium.

The IRS has clarified its position on many issues with respect to mid-year elections, but a number of questions remain unanswered. In view of the likelihood that the NPRs will be substantially unchanged when finalized, it is advisable for plan sponsors to comply with the New Proposed Regulations (as well as the Final Regulations) in order to permit the establishment of a viable administrative framework which can be communicated to participating employees, effective for the first day of a cafeteria plan year in 2001.

© 2000 Greenberg Traurig