[Federal Register Volume 66, Number 7 (Wednesday, January 10, 2001)]
[Rules and Regulations]
[Pages 1837-1843]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 01-258]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8921]
RIN 1545-AY23


Tax Treatment of Cafeteria Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains final regulations relating to section 
125 cafeteria plans. The final regulations clarify the circumstances 
under which a cafeteria plan may permit an employee to change his or 
her cafeteria plan election with respect to accident or health 
coverage, group-term life insurance coverage, dependent care assistance 
and adoption assistance during the plan year.

DATES: Effective Date: These regulations are effective January 10, 
2001.
    Applicability Date: See the Scope of Regulations and Effective Date 
portion of this preamble.

FOR FURTHER INFORMATION CONTACT: Christine L. Keller or Janet A. Laufer 
at (202) 622-6080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

    This document contains amendments to the Income Tax Regulations (26 
CFR part 1) under section 125 of the Internal Revenue Code (Code). 
Section 125 generally provides that an employee in a cafeteria plan 
will not have an amount included in gross income solely because the 
employee may choose among two or more benefits consisting of cash and 
qualified benefits. A qualified benefit generally is any benefit that 
is excludable from gross income under an express provision of the Code, 
including coverage under an employer-provided accident or health plan 
under sections 105 and 106, group-term life insurance under section 79, 
elective contributions under a qualified cash or deferred arrangement 
within the meaning of section 401(k), dependent care assistance under 
section 129, and adoption assistance under section 137.\1\ Qualified 
benefits can be provided under a cafeteria plan either through insured 
arrangements or arrangements that are not insured.
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    \1\ Section 125(f) provides that the following are not qualified 
benefits (even though they are generally excludable from gross 
income under an express provision of the Internal Revenue Code: 
Products advertised, marketed, or offered as long-term care 
insurance; medical savings accounts under section 106(b); qualified 
scholarships under section 117; educational assistance programs 
under section 127; and fringe benefits under section 132.
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    In 1984 and 1989, proposed regulations were published relating to 
cafeteria plans.\2\ In general, the 1984 and 1989 proposed regulations 
require that, for benefits to be provided on a pre-tax basis under 
section 125, an employee may make changes during a plan year only in 
certain circumstances. Specifically, Q&A-8 of Sec. 1.125-1 and Q&A-
6(b), (c), and (d) of Sec. 1.125-2 permit participants to make benefit 
election changes during a plan year pursuant to changes in cost or 
coverage,

[[Page 1838]]

changes in family status, and separation from service.
    In 2000, final regulations \3\ were issued permitting a participant 
in a cafeteria plan to change his or her accident or health coverage 
election during a period of coverage in specific circumstances such as 
where special enrollment rights arise under section 9801(f) (added to 
the Code by the Health Insurance Portability and Accountability Act of 
1996 (HIPAA)(110 Stat. 1936), where eligibility for Medicare or 
Medicaid is gained or lost, or where a court issues a judgment, decree, 
or order requiring that an employee's child or foster child who is a 
dependent receive health coverage. In addition, the final regulations 
permit an employee to change his or her accident or health coverage 
election or group-term life insurance election if certain change in 
status rules are satisfied.
    On the same day that the final regulations were issued, proposed 
regulations \4\ were also issued containing change in status rules that 
apply to other types of qualified benefits (i.e., dependent care 
assistance and adoption assistance) and describing the circumstances 
under which changes in the cost or coverage of qualified benefits 
provide a basis for changes in cafeteria plan elections. The IRS and 
Treasury received written comments on the proposed regulations and held 
a public hearing on August 17, 2000. Having considered the comments and 
the statements made at the hearing, the IRS and Treasury revise the 
final regulations and adopt the proposed regulations as modified by 
this Treasury decision. The comments and revisions are discussed below.
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    \2\ 49 FR 19321 (May 7, 1984) and 54 FR 9460 (March 7, 1989), 
respectively.
    \3\ TD 8878 at 65 FR 15548 (March 23, 2000). These final 
regulations were preceded by temporary regulations issued in 1997. 
See 62 FR 60196 (November 7, 1997) and 62 FR 60165 (November 7, 
1997).
    \4\ REG-117162-99 at 65 FR 15587 (March 23, 2000).
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Explanation of Provisions

1. Changes in the March 2000 Final Regulations

    With respect to group-term life insurance and disability coverage, 
the final regulations issued earlier this year provided flexibility by 
stating that, in the event of a change in an employee's marital status 
or a change in the employment status of the employee's spouse or 
dependent, an employee may elect either to increase such coverage or to 
decrease such coverage.\5\ Commentators recommended that this rule also 
apply in the case of birth, adoption, placement for adoption, or death. 
The argument was made that in these other situations--because these 
types of coverage are generally designed to provide income, instead of 
expense reimbursements--it may be appropriate for the employee to seek 
to increase or decrease the coverage. In accordance with these 
recommendations and in the interest of simplicity, the final 
regulations have been modified to allow participants to increase or 
decrease these types of coverage for all change of status events. 
Further, as also suggested by commentators, the final regulations have 
been modified to expand the rule to apply to coverage to which section 
105(c) (which is coverage for permanent loss or loss of use of a member 
or function of the body) applies.
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    \5\ For example, an employee might seek to increase group-item 
life insurance due to a marriage (because of the need to provide 
income to the new spouse in the event that the chief wage-earner 
dies) or to decrease group-term life insurance due to a marriage 
(because the new spouse may be a wage-earner who can support the 
family in the event that the employee dies).
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    Commentators requested clarification as to how the election change 
rules with respect to special enrollment rights under section 9801(f) 
(enacted under HIPAA) apply to a participant who marries if the group 
health plan allows the participant to change his or her health coverage 
election retroactively to the date of the marriage. In response to this 
comment, language has been added to an example in the final regulations 
to clarify that an election change can be funded through salary 
reduction under a cafeteria plan only on a prospective basis, except 
for the retroactive enrollment right under section 9801(f) that applies 
in the case of an election made within 30 days of a birth, adoption, or 
placement for adoption.
    With respect to accident or health coverage, the consistency rule 
in the final regulations requires that any employee who wishes to 
decrease or cancel coverage because he or she becomes eligible for 
coverage under a spouse's or dependent's plan due to a marital or 
employment change in status can do so only if he or she actually 
obtains coverage under that other plan. Commentators requested 
clarification as to the type of proof an employer must receive to 
satisfy this rule, expressing concern that a plan could not implement a 
change on a timely basis because of a need to obtain proper proof of 
the other coverage. An example in the final regulations has been 
revised to make it clear that employers may generally rely on an 
employee's certification that the employee has or will obtain coverage 
under the other plan (assuming that the employer has no reason to 
believe that the employee certification is incorrect).
    The final regulations allow a participant to change his or her 
election if a judgment, decree or order resulting from a divorce, legal 
separation, annulment, or change in legal custody requires that an 
employee's spouse, former spouse, or other individual provide accident 
or health coverage for the employee's child or for a foster child who 
is a dependent of the employee. The final regulations were modified to 
clarify that the participant can only change his or her election if the 
spouse, former spouse, or other individual actually provides accident 
or health coverage for the child.

2. Changes From the March 2000 Proposed Regulations

    The final regulations being issued today are generally consistent 
with the proposed regulations that were issued earlier this year, but 
include various modifications.

Cost and coverage rules

    The proposed regulations included rules allowing election changes 
in connection with a significant increase in cost or a significant 
curtailment in coverage, irrespective of whether the plan is insured or 
not insured. These cost and coverage rules (and the other rules in 
paragraph (f) of Sec. 1.125-4) do not apply with respect to coverage 
under a health FSA.\6\ However, all of the rules in paragraphs (a) 
through (e) and paragraph (g) of the final regulations under 
Sec. 1.125-4 do apply with respect to coverage under a health FSA. One 
modification reflected in the final regulations is to clarify that the 
cost increase rules apply when the amount of an employee's elective 
contributions under section 125 increases either due to the employee 
contributing a larger portion of the total cost of the qualified 
benefits plan (which might occur, for example, if part-time employees 
pay a larger portion of a plan's cost and the employee switches to 
part-time status) or due to an increase in the total cost of the 
qualified benefits plan.
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    \6\ A flexible spending arrangement (FSA) is defined in section 
106(c)(2). Under section 106(c)(2), an FSA is generally a benefit 
program under which the maximum reimbursement reasonably available 
for coverage is less than 500% of the value of the coverage. A 
health FSA is an accident or health plan that is an FSA.
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    In response to comments, modifications were also made to allow 
election changes during a period of coverage when there is a 
significant decrease in the cost of a qualified benefits plan or in the 
cost of a benefits package option under the qualified

[[Page 1839]]

benefits plan, as well as when there is a significant increase. Under 
the regulations as modified, if there is a significant decrease in the 
cost of a qualified benefits plan during the plan year, the final 
regulations permit a cafeteria plan to allow all employees, even those 
who have not previously participated in the cafeteria plan, to elect to 
participate in the qualified benefits plan through the cafeteria plan. 
Similarly, if there is a significant decrease in the cost of a benefits 
package option during the plan year, the final regulations permit a 
cafeteria plan to allow all eligible employees to elect that option 
(including employees who have elected another option, as well as those 
who have not previously participated in the cafeteria plan).
    Further, in response to comments, modifications were also made to 
allow midyear election changes when there is a significant improvement 
in the coverage provided under a benefit package option, as well as 
when there is a new benefit package option offered under the plan.
    Commentators also requested clarification as to whether a cafeteria 
plan could allow participants to drop coverage in response to a 
significant change in the cost or coverage of a qualified benefit. The 
final regulations clarify this issue, and provide that, if there is no 
other similar coverage, employees may drop coverage (including a change 
from family to single coverage) in response either to an increase in 
the cost of a qualified benefit or to a loss of coverage. The 
regulations also permit an employee to elect similar coverage in 
response to a significant curtailment in coverage. However, the 
regulations do not allow an employee to drop coverage altogether if 
there is a significant curtailment in coverage that does not constitute 
a loss of coverage. The regulations list the curtailments that are 
treated as a loss of coverage for this purpose, and include a complete 
loss of coverage (such as when an HMO ceases to be available in an area 
where an individual resides, or when an employee or a covered member of 
the employee's family loses all coverage under a benefit package option 
by reason of a lifetime or annual limitation). In addition, the final 
regulations allow a cafeteria plan, in its discretion,\7\ to treat 
certain other events as a loss of coverage. These events include a 
substantial decrease in medical care providers (such as a major 
hospital ceasing to be a member of a preferred provider network or a 
substantial decease in the physicians participating in a preferred 
provider network or an HMO), a reduction in the benefits for a specific 
type of medical condition or treatment with respect to which the 
employee or the employee's spouse or dependent is currently in a course 
of treatment,\8\ or any other similar fundamental loss of coverage.
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    \7\ Such discretion may be exercised on a case by case basis, 
provided that the exercise of discretion satisfies section 125(c) 
which prohibits discrimination in favor of highly compensated 
participants.
    \8\ Any reduction in coverage that affects a specific individual 
must not violate the prohibition in section 9802 against 
discrimination on the basis of health status (and parallel HIPAA 
provisions in the Employee Retirment Income Security Act of 1974 and 
the Public Health Service Act). See Secs. 54.9802-1 and 54.9802-
1T(b)(2).
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    For purposes of these rules, a significant curtailment occurs only 
if there is an overall reduction in coverage provided so as to 
constitute reduced coverage generally (i.e., a reduction in the fair 
market value of the coverage). Therefore, in most cases, the loss of 
one particular physician in a network does not constitute a significant 
curtailment.
    In response to comments, the rule under the proposed regulations 
that allowed an employee to change his or her election in response to a 
change made under a spouse's or dependent's plan has been clarified and 
broadened. Under the final regulations, the rule applies to coverage 
available from any employer plan, including any plan of the same 
employer and any plan of a different employer. In addition, the 
regulations have been modified to allow an employee to elect to 
participate in a cafeteria plan if the employee (or the employee's 
spouse or dependent) loses coverage under a group health plan sponsored 
by a governmental or educational institution, such as a state program 
under the State Children Health Insurance Program (SCHIP).\9\ The 
regulations do not allow a cafeteria plan participant to cease 
participation in a cafeteria plan if he or she becomes eligible for 
SCHIP coverage during the year because of a concern that such a rule 
would violate a fundamental principle of Title XXI of the Social 
Security Act that SCHIP coverage not supplant existing public or 
private coverage.
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    \9\ Added to the Society Security Act by section 4901 of the 
Balanced Budget Act of 1997, Public Law 105-33 (August 5, 1997).
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Scope of Regulations and Effective Date

    These final regulations address all of the changes in status for 
which a cafeteria plan may permit election changes, including changes 
with respect to accident or health coverage, group-term life insurance, 
dependent care assistance and adoption assistance. In addition, the 
regulations contain guidance concerning election changes that are 
permitted because of changes in the cost or coverage of a qualified 
benefit plan.
    Unless specifically noted, these regulations do not override other 
cafeteria plan requirements such as the rules pertaining to health 
flexible spending arrangements, and the rules concerning the Family and 
Medical Leave Act (Public Law 103-3 (107 Stat. 6)).\10\
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    \10\ See Sec. 1.125-3, published as a proposed rule at 60 FR 
66229 (December 21, 1995).
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    The changes made by these regulations with respect to the March 
2000 final regulations are applicable for cafeteria plan years 
beginning on or after January 1, 2001, except that the clarification 
made in paragraph (d)(1)(ii)(B) of these regulations (relating to a 
spouse, former spouse, or other individual obtaining accident or health 
coverage for an employee's child in response to a judgment, decree, or 
order) is applicable for cafeteria plan years beginning on or after 
January 1, 2002. With respect to the change made in paragraph 
(d)(1)(ii)(B) of these regulations, taxpayers may, until January 1, 
2002, rely on either paragraph (d)(1)(ii)(B) of these regulations or 
the final regulations published in March 2000 (as Sec. 1.125-
4(d)(1)(ii)).
    The changes made from the March 2000 proposed regulations 
(including the rules relating to cost or coverage in paragraph (f) of 
these regulations) are applicable for cafeteria plan years beginning on 
or after January 1, 2002. With respect to these changes (including the 
rules relating to cost or coverage in paragraph (f) of these 
regulations), taxpayers may, until January 1, 2002, rely on either 
these regulations, the proposed regulations published in March 2000 
(under Sec. 1.125-4), or the cost or coverage change rules in the 1989 
proposed regulations (at Sec. 1.125-2 (Q&A-6(b)).

Special Analyses

    It has been determined that this Treasury decision is not a 
significant regulatory action as defined in Executive Order 12866. 
Therefore, a regulatory assessment is not required. It also has been 
determined that section 553(b) of the Administrative Procedure Act (5 
U.S.C. chapter 5) does not apply to these regulations, and because the 
regulation does not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Internal Revenue Code, these 
regulations will be

[[Page 1840]]

submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small business.

Drafting Information

    The principal authors of these regulations are Christine L. Keller 
and Janet A. Laufer, Office of Division Counsel/Associate Chief Counsel 
(Tax Exempt and Government Entities). However, other personnel from the 
IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Adoption of Amendments to the Regulations

    Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. 1.125-4 is amended by:
    1. Revising paragraphs (b)(2) Example 2(ii).

    2. Revising paragraph (c)(1) and adding paragraph (c)(2)(vi).

    3. Adding a sentence to the end of paragraph (c)(3)(i).

    4. Removing the last sentence in paragraph (c)(3)(iii) and adding a 
sentence in its place.

    5. Adding paragraph (c)(4) Example 3 (iii).

    6. Revising paragraph (c)(4) Example 4 (ii) and adding paragraph 
(iii).

    7. Adding paragraph (c)(4) Example 9 and (c)(4) Example 10.

    8. Revising paragraph (d)(1)(ii).

    9. Revising paragraphs (f), (g), (i)(3) and (i)(4).

    10. Adding a sentence at the end of paragraph (i)(8), and adding 
paragraph (i)(9).

    11. Revising paragraph (j).
    The additions and revisions read as follows:


Sec. 1.125-4  Permitted election changes.

* * * * *
    (b) * * *
    (2) * * *

    Example 2. * * *
    (ii) M's cafeteria plan may permit E to change E's salary 
reduction election to reflect the change to family coverage under 
M's accident or health plan because the marriage would result in 
special enrollment rights under section 9801(f), pursuant to which 
an election of family coverage under M's accident or health plan 
would be required to be effective no later than the first day of the 
first calendar month beginning after the completed request for 
enrollment is received by the plan. Since no retroactive coverage is 
required in the event of marriage under section 9801(f), E's salary 
reduction election may only be changed on a prospective basis. (E's 
marriage to F is also a change in status under paragraph (c) of this 
section, as illustrated in Example 1 of paragraph (c)(4) of this 
section.)
    (c) Changes in status--(1) Change in status rule. A cafeteria plan 
may permit an employee to revoke an election during a period of 
coverage with respect to a qualified benefits plan (defined in 
paragraph (i)(8) of this section) to which this paragraph (c) applies 
and make a new election for the remaining portion of the period 
(referred to in this section as an election change) if, under the facts 
and circumstances--
    (i) A change in status described in paragraph (c)(2) of this 
section occurs; and
    (ii) The election change satisfies the consistency rule of 
paragraph (c)(3) of this section.
* * * * *
    (2) * * *
    (vi) Adoption assistance. For purposes of adoption assistance 
provided through a cafeteria plan, the commencement or termination of 
an adoption proceeding.
    (3) Consistency rule--(i) Application to accident or health 
coverage and group-term life insurance. * * * A change in status that 
affects eligibility under an employer's plan includes a change in 
status that results in an increase or decrease in the number of an 
employee's family members or dependents who may benefit from coverage 
under the plan.
* * * * *
    (iii) Application of consistency rule. * * * With respect to group-
term life insurance and disability coverage (as defined in paragraph 
(i)(4) of this section), an election under a cafeteria plan to increase 
coverage (or an election to decrease coverage) in response to a change 
in status described in paragraph (c)(2) of this section is deemed to 
correspond with that change in status as required by paragraph 
(c)(3)(i) of this section.
    (4) * * *

    Example 3. * * *
    (iii) In addition, under paragraph (f)(4) of this section, if F 
makes an election change to cover G under F's employer's plan, then 
E may make a corresponding change to elect employee-only coverage 
under P's cafeteria plan.
    Example 4. * * *
    (ii) The transfer is a change in status under paragraph 
(c)(2)(iii) of this section (relating to a change in worksite), and, 
under the consistency rule in paragraph (c)(3) of this section, the 
cafeteria plan may permit A to make an election change to elect the 
indemnity option or HMO #2 or to cancel accident or health coverage.
    (iii) The change in work location has no effect on A's 
eligibility under R's health FSA, so no change in A's health FSA is 
authorized under this paragraph (c).
* * * * *
    Example 9. (i) Employee A has one child, B. Employee A's 
employer, X, maintains a calendar year cafeteria plan that allows 
employees to elect coverage under a dependent care FSA. Prior to the 
beginning of the calendar year, A elects salary reduction 
contributions of $4,000 during the year to fund coverage under the 
dependent care FSA for up to $4,000 of reimbursements for the year. 
During the year, B reaches the age of 13, and A wants to cancel 
coverage under the dependent care FSA.
    (ii) When B turns 13, B ceases to satisfy the definition of 
qualifying individual under section 21(b)(1) of the Internal Revenue 
Code. Accordingly, B's attainment of age 13 is a change in status 
under paragraph (c)(2)(iv) of this section that affects A's 
employment-related expenses as defined in section 21(b)(2). 
Therefore, A may make a corresponding change under X's cafeteria 
plan to cancel coverage under the dependent care FSA.
    Example 10. (i) Employer Y maintains a calendar year cafeteria 
plan under which full-time employees may elect coverage under either 
an indemnity option or an HMO. Employee C elects the employee-only 
indemnity option. During the year, C marries D. D has two children 
from a previous marriage, and has family group health coverage in a 
cafeteria plan sponsored by D's employer, Z. C wishes to change from 
employee-only indemnity coverage to HMO coverage for the family. D 
wishes to cease coverage in Z's group health plan and certifies to Z 
that D will have family coverage under C's plan (and Z has no reason 
to believe the certification is incorrect).
    (ii) The marriage is a change in status under paragraph 
(c)(2)(i) of this section. Under the consistency rule in paragraph 
(c)(3) of this section, Y's cafeteria plan may permit C to change 
his or her salary reduction contributions to reflect the change from 
employee-only indemnity to HMO family coverage, and Z may permit D 
to revoke coverage under Z's cafeteria plan.

    (d) * * * (1) * * *
    (ii) Permits the employee to make an election change to cancel 
coverage for the child if:
    (A) The order requires the spouse, former spouse, or other 
individual to provide coverage for the child; and
    (B) That coverage is, in fact, provided.
* * * * *
    (f) Significant cost or coverage changes--(1) In general. 
Paragraphs (f)(2) through (5) of this section set forth rules for 
election changes as a result of changes in cost or coverage. This 
paragraph (f) does not apply to an

[[Page 1841]]

election change with respect to a health FSA (or on account of a change 
in cost or coverage under a health FSA).
    (2) Cost changes--(i) Automatic changes. If the cost of a qualified 
benefits plan increases (or decreases) during a period of coverage and, 
under the terms of the plan, employees are required to make a 
corresponding change in their payments, the cafeteria plan may, on a 
reasonable and consistent basis, automatically make a prospective 
increase (or decrease) in affected employees' elective contributions 
for the plan.
    (ii) Significant cost changes. If the cost charged to an employee 
for a benefit package option (as defined in paragraph (i)(2) of this 
section) significantly increases or significantly decreases during a 
period of coverage, the cafeteria plan may permit the employee to make 
a corresponding change in election under the cafeteria plan. Changes 
that may be made include commencing participation in the cafeteria plan 
for the option with a decrease in cost, or, in the case of an increase 
in cost, revoking an election for that coverage and, in lieu thereof, 
either receiving on a prospective basis coverage under another benefit 
package option providing similar coverage or dropping coverage if no 
other benefit package option providing similar coverage is available. 
For example, if the cost of an indemnity option under an accident or 
health plan significantly increases during a period of coverage, 
employees who are covered by the indemnity option may make a 
corresponding prospective increase in their payments or may instead 
elect to revoke their election for the indemnity option and, in lieu 
thereof, elect coverage under another benefit package option including 
an HMO option (or drop coverage under the accident or health plan if no 
other benefit package option is offered).
    (iii) Application of cost changes. For purposes of paragraphs 
(f)(2)(i) and (ii) of this section, a cost increase or decrease refers 
to an increase or decrease in the amount of the elective contributions 
under the cafeteria plan, whether that increase or decrease results 
from an action taken by the employee (such as switching between full-
time and part-time status) or from an action taken by an employer (such 
as reducing the amount of employer contributions for a class of 
employees).
    (iv) Application to dependent care. This paragraph (f)(2) applies 
in the case of a dependent care assistance plan only if the cost change 
is imposed by a dependent care provider who is not a relative of the 
employee. For this purpose, a relative is an individual who is related 
as described in section 152(a)(1) through (8), incorporating the rules 
of section 152(b)(1) and (2).
    (3) Coverage changes--(i) Significant curtailment without loss of 
coverage. If an employee (or an employee's spouse or dependent) has a 
significant curtailment of coverage under a plan during a period of 
coverage that is not a loss of coverage as described in paragraph 
(f)(3)(ii) of this section (for example, there is a significant 
increase in the deductible, the copay, or the out-of-pocket cost 
sharing limit under an accident or health plan), the cafeteria plan may 
permit any employee who had been participating in the plan and 
receiving that coverage to revoke his or her election for that coverage 
and, in lieu thereof, to elect to receive on a prospective basis 
coverage under another benefit package option providing similar 
coverage. Coverage under a plan is significantly curtailed only if 
there is an overall reduction in coverage provided under the plan so as 
to constitute reduced coverage generally. Thus, in most cases, the loss 
of one particular physician in a network does not constitute a 
significant curtailment.
    (ii) Significant curtailment with loss of coverage. If an employee 
(or the employee's spouse or dependent) has a significant curtailment 
that is a loss of coverage, the plan may permit that employee to revoke 
his or her election under the cafeteria plan and, in lieu thereof, to 
elect either to receive on a prospective basis coverage under another 
benefit package option providing similar coverage or to drop coverage 
if no similar benefit package option is available. For purposes of this 
paragraph (f)(3)(ii), a loss of coverage means a complete loss of 
coverage under the benefit package option or other coverage option 
(including the elimination of a benefits package option, an HMO ceasing 
to be available in the area where the individual resides, or the 
individual losing all coverage under the option by reason of an overall 
lifetime or annual limitation). In addition, the cafeteria plan may, in 
its discretion, treat the following as a loss of coverage--
    (A) A substantial decrease in the medical care providers available 
under the option (such as a major hospital ceasing to be a member of a 
preferred provider network or a substantial decrease in the physicians 
participating in a preferred provider network or an HMO);
    (B) A reduction in the benefits for a specific type of medical 
condition or treatment with respect to which the employee or the 
employee's spouse or dependent is currently in a course of treatment; 
or
    (C) Any other similar fundamental loss of coverage.
    (iii) Addition or improvement of a benefit package option. If a 
plan adds a new benefit package option or other coverage option, or if 
coverage under an existing benefit package option or other coverage 
option is significantly improved during a period of coverage, the 
cafeteria plan may permit eligible employees (whether or not they have 
previously made an election under the cafeteria plan or have previously 
elected the benefit package option) to revoke their election under the 
cafeteria plan and, in lieu thereof, to make an election on a 
prospective basis for coverage under the new or improved benefit 
package option.
    (4) Change in coverage under another employer plan. A cafeteria 
plan may permit an employee to make a prospective election change that 
is on account of and corresponds with a change made under another 
employer plan (including a plan of the same employer or of another 
employer) if--
    (i) The other cafeteria plan or qualified benefits plan permits 
participants to make an election change that would be permitted under 
paragraphs (b) through (g) of this section (disregarding this paragraph 
(f)(4)); or
    (ii) The cafeteria plan permits participants to make an election 
for a period of coverage that is different from the period of coverage 
under the other cafeteria plan or qualified benefits plan.
    (5) Loss of coverage under other group health coverage. A cafeteria 
plan may permit an employee to make an election on a prospective basis 
to add coverage under a cafeteria plan for the employee, spouse, or 
dependent if the employee, spouse, or dependent loses coverage under 
any group health coverage sponsored by a governmental or educational 
institution, including the following--
    (i) A State's children's health insurance program (SCHIP) under 
Title XXI of the Social Security Act;
    (ii) A medical care program of an Indian Tribal government (as 
defined in section 7701(a)(40)), the Indian Health Service, or a tribal 
organization
    (iii) A State health benefits risk pool; or
    (iv) A Foreign government group health plan.
    (6) Examples. The following examples illustrate the application of 
this paragraph (f):

    Example 1. (i) A calendar year cafeteria plan is maintained 
pursuant to a collective

[[Page 1842]]

bargaining agreement for the benefit of Employer M's employees. The 
cafeteria plan offers various benefits, including indemnity health 
insurance and a health FSA. As a result of mid-year negotiations, 
premiums for the indemnity health insurance are reduced in the 
middle of the year, insurance co-payments for office visits are 
reduced under the indemnity plan by an amount which constitutes a 
significant benefit improvement, and an HMO option is added.
    (ii) Under these facts, the reduction in health insurance 
premiums is a reduction in cost. Accordingly, under paragraph 
(f)(2)(i) of this section, the cafeteria plan may automatically 
decrease the amount of salary reduction contributions of affected 
participants by an amount that corresponds to the premium change. 
However, the plan may not permit employees to change their health 
FSA elections to reflect the mid-year change in copayments under the 
indemnity plan.
    (iii) Also, the decrease in co-payments is a significant benefit 
improvement and the addition of the HMO option is an addition of a 
benefit package option. Accordingly, under paragraph (f)(3)(ii) of 
this section, the cafeteria plan may permit eligible employees to 
make an election change to elect the indemnity plan or the new HMO 
option. However, the plan may not permit employees to change their 
health FSA elections to reflect differences in co-payments under the 
HMO option.
    Example 2. (i) Employer N sponsors an accident or health plan 
under which employees may elect either employee-only coverage or 
family health coverage. The 12-month period of coverage under N's 
cafeteria plan begins January 1, 2001. N's employee, A, is married 
to B. Employee A elects employee-only coverage under N's plan. B's 
employer, O, offers health coverage to O's employees under its 
accident or health plan under which employees may elect either 
employee-only coverage or family coverage. O's plan has a 12-month 
period of coverage beginning September 1, 2001. B maintains 
individual coverage under O's plan at the time A elects coverage 
under N's plan, and wants to elect no coverage for the plan year 
beginning on September 1, 2001, which is the next period of coverage 
under O's accident or health plan. A certifies to N that B will 
elect no coverage under O's accident or health plan for the plan 
year beginning on September 1, 2001 and N has no reason to believe 
that A's certification is incorrect.
    (ii) Under paragraph (f)(4)(ii) of this section, N's cafeteria 
plan may permit A to change A's election prospectively to family 
coverage under that plan effective September 1, 2001.
    Example 3. (i) Employer P sponsors a calendar year cafeteria 
plan under which employees may elect either employee-only or family 
health coverage. Before the beginning of the year, P's employee, C, 
elects family coverage under P's cafeteria plan. C also elects 
coverage under the health FSA for up to $200 of reimbursements for 
the year to be funded by salary reduction contributions of $200 
during the year. C is married to D, who is employed by Employer Q. Q 
does not maintain a cafeteria plan, but does maintain an accident or 
health plan providing its employees with employee-only coverage. 
During the calendar year, Q adds family coverage as an option under 
its health plan. D elects family coverage under Q's plan, and C 
wants to revoke C's election for health coverage and elect no health 
coverage under P's cafeteria plan for the remainder of the year.
    (ii) Q's addition of family coverage as an option under its 
health plan constitutes a new coverage option described in paragraph 
(f)(3)(ii) of this section. Accordingly, pursuant to paragraph 
(f)(4)(i) of this section, P's cafeteria plan may permit C to revoke 
C's health coverage election if D actually elects family health 
coverage under Q's accident or health plan. Employer P's plan may 
not permit C to change C's health FSA election.
    Example 4. (i) Employer R maintains a cafeteria plan under which 
employees may elect accident or health coverage under either an 
indemnity plan or an HMO. Before the beginning of the year, R's 
employee, E elects coverage under the HMO at a premium cost of $100 
per month. During the year, E decides to switch to the indemnity 
plan, which charges a premium of $140 per month.
    (ii) E's change from the HMO to indemnity plan is not a change 
in cost or coverage under this paragraph (f), and none of the other 
election change rules under paragraphs (b) through (e) of this 
section apply.
    (iii) Although R's health plan may permit E to make the change 
from the HMO to the indemnity plan, R's cafeteria plan may not 
permit E to make an election change to reflect the increased 
premium. Accordingly, if E switches from the HMO to the indemnity 
plan, E may pay the $40 per month additional cost on an after-tax 
basis.
    Example 5. (i) Employee A is married to Employee B and they have 
one child, C. Employee A's employer, M, maintains a calendar year 
cafeteria plan that allows employees to elect coverage under a 
dependent care FSA. Child C attends X's on site child care center at 
an annual cost of $3,000. Prior to the beginning of the year, A 
elects salary reduction contributions of $3,000 during the year to 
fund coverage under the dependent care FSA for up to $3,000 of 
reimbursements for the year. Employee A now wants to revoke A's 
election of coverage under the dependent care FSA, because A has 
found a new child care provider.
    (ii) The availability of dependent care services from the new 
child care provider (whether the new provider is a household 
employee or family member of A or B or a person who is independent 
of A and B) is a significant change in coverage similar to a benefit 
package option becoming available. Because the FSA is a dependent 
care FSA rather than a health FSA, the coverage rules of this 
section apply and M's cafeteria plan may permit A to elect to revoke 
A's previous election of coverage under the dependent care FSA, and 
make a corresponding new election to reflect the cost of the new 
child care provider.
    Example 6. (i) Employee D is married to Employee E and they have 
one child, F. Employee D's employer, N, maintains a calendar year 
cafeteria plan that allows employees to elect coverage under a 
dependent care FSA. Child F is cared for by Y, D's household 
employee, who provides child care services five days a week from 9 
a.m. to 6 p.m. at an annual cost in excess of $5,000. Prior to the 
beginning of the year, D elects salary reduction contributions of 
$5,000 during the year to fund coverage under the dependent care FSA 
for up to $5,000 of reimbursements for the year. During the year, F 
begins school and, as a result, Y's regular hours of work are 
changed to five days a week from 3 p.m. to 6 p.m. Employee D now 
wants to revoke D's election under the dependent care FSA, and make 
a new election under the dependent care FSA to an annual cost of 
$4,000 to reflect a reduced cost of child care due to Y's reduced 
hours.
    (ii) The change in the number of hours of work performed by Y is 
a change in coverage. Thus, N's cafeteria plan may permit D to 
reduce D's previous election under the dependent care FSA to $4,000.
    Example 7. (i) Employee G is married to Employee H and they have 
one child, J. Employee G's employer, O, maintains a calendar year 
cafeteria plan that allows employees to elect coverage under a 
dependent care FSA. Child J is cared for by Z, G's household 
employee, who is not a relative of G and who provides child care 
services at an annual cost of $4,000. Prior to the beginning of the 
year, G elects salary reduction contributions of $4,000 during the 
year to fund coverage under the dependent care FSA for up to $4,000 
of reimbursements for the year. During the year, G raises Z's 
salary. Employee G now wants to revoke G's election under the 
dependent care FSA, and make a new election under the dependent care 
FSA to an annual amount of $4,500 to reflect the raise.
    (ii) The raise in Z's salary is a significant increase in cost 
under paragraph (f)(2)(ii) of this section, and an increase in 
election to reflect the raise corresponds with that change in 
status. Thus, O's cafeteria plan may permit G to elect to increase 
G's election under the dependent care FSA.
    Example 8. (i) Employer P maintains a calendar year cafeteria 
plan that allows employees to elect employee-only, employee plus one 
dependent, or family coverage under an indemnity plan. During the 
middle of the year, Employer P gives its employees the option to 
select employee-only or family coverage from an HMO plan. P's 
employee, J, who had elected employee plus one dependent coverage 
under the indemnity plan, decides to switch to family coverage under 
the HMO plan.
    (ii) Employer P's midyear addition of the HMO option is an 
addition of a benefit package option. Under paragraph (f) of this 
section, Employee J may change his or her salary reduction 
contributions to reflect the change from indemnity to HMO coverage, 
and also to reflect the change from employee plus one dependent to 
family coverage (however, an election of employee-only coverage 
under the new option would not correspond with the addition of a new 
option). Employer P may not permit J to change J's health FSA 
election.


[[Page 1843]]


    (g) Special requirements relating to the Family and Medical Leave 
Act. An employee taking leave under the Family and Medical Leave Act 
(FMLA) (Public Law 103-3 (107 Stat. 6)) may revoke an existing election 
of accident or health plan coverage and make such other election for 
the remaining portion of the period of coverage as may be provided for 
under the FMLA.
* * * * *
    (i) * * *
    (3) Dependent. A dependent means a dependent as defined in section 
152, except that, for purposes of accident or health coverage, any 
child to whom section 152(e) applies is treated as a dependent of both 
parents, and, for purposes of dependent care assistance provided 
through a cafeteria plan, a dependent means a qualifying individual (as 
defined in section 21(b)(1)) with respect to the employee.
    (4) Disability coverage. Disability coverage means coverage under 
an accident or health plan that provides benefits due to personal 
injury or sickness, but does not reimburse expenses incurred for 
medical care (as defined in section 213(d)) of the employee or the 
employee's spouse and dependents. For purposes of this section, 
disability coverage includes payments described in section 105(c).
* * * * *
    (8) Qualified benefits plan. * * * A plan does not fail to be a 
qualified benefits plan merely because it includes an FSA, assuming 
that the FSA meets the requirements of section 125 and the regulations 
thereunder.
    (9) Similar coverage. Coverage for the same category of benefits 
for the same individuals (e.g., family to family or single to single). 
For example, two plans that provide coverage for major medical are 
considered to be similar coverage. For purposes of this definition, a 
health FSA is not similar coverage with respect to an accident or 
health plan that is not a health FSA. A plan may treat coverage by 
another employer, such as a spouse's or dependent's employer, as 
similar coverage.
    (j) Effective date--(1) General rule. Except as provided in 
paragraph (j)(2) of this section, this section is applicable for 
cafeteria plan years beginning on or after January 1, 2001.
    (2) Delayed effective date for certain provisions. The following 
provisions are applicable for cafeteria plan years beginning on or 
after January 1, 2002: paragraph (c) of this section to the extent 
applicable to qualified benefits other than an accident or health plan 
or a group-term life insurance plan; paragraph (d)(1)(ii)(B) of this 
section (relating to a spouse, former spouse, or other individual 
obtaining accident or health coverage for an employee's child in 
response to a judgment, decree, or order); paragraph (f) of this 
section (rules for election changes as a result of cost or coverage 
changes); and paragraph (i)(9) of this section (defining similar 
coverage).


Sec. 1.125-4T  [Removed]

    Par. 3. Section 1.125-4T is removed.

Robert E. Wenzel,
Deputy Commissioner of Internal Revenue.

    Approved: December 15, 2000.
Jonathan Talisman,
Acting Assistant Secretary of the Treasury (Tax Policy).
[FR Doc. 01-258 Filed 1-9-01; 8:45 am]
BILLING CODE 4830-01-P