[Federal Register Volume 72, Number 150 (Monday, August 6, 2007)]
[Proposed Rules]
[Pages 43938-43968]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: E7-14827]



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Part III





Department of the Treasury





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Internal Revenue Service



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26 CFR Part 1



Employee Benefits--Cafeteria Plans; Proposed Rule

  Federal Register / Vol. 72, No. 150 / Monday, August 6, 2007 / 
Proposed Rules  

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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-142695-05]
RIN 1545-BF00


Employee Benefits--Cafeteria Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Withdrawal of prior notices of proposed rulemaking, notice of 
proposed rulemaking and notice of public hearing.

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SUMMARY: This document contains new proposed regulations providing 
guidance on cafeteria plans. This document also withdraws the notices 
of proposed rulemaking relating to cafeteria plans under section 125 
that were published on May 7, 1984, December 31, 1984, March 7, 1989, 
November 7, 1997 and March 23, 2000. In general, these proposed 
regulations would affect employers that sponsor a cafeteria plan, 
employees that participate in a cafeteria plan, and third-party 
cafeteria plan administrators.

DATES: Written or electronic comments must be received by November 5, 
2007. Outlines of topics to be discussed at the hearing scheduled for 
November 15, 2007, at 10 a.m., must be received by October 25, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-142695-05), room 
5203, Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
142695-05), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC or sent electronically via the Federal 
eRulemaking Portal at http://www.regulations.gov (IRS REG-142695-05). 
The public hearing will be held at the IRS Auditorium, Internal Revenue 
Building, 1111 Constitution Avenue, NW., Washington, DC.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Mireille T. Khoury at (202) 622-6080; concerning submissions of 
comments, the hearing, and/or to be placed on the building access list 
to attend the hearing, Oluwafunmilayo Taylor of the Publications and 
Regulations Branch at (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION

Paperwork Reduction Act

    The collections of information contained in this notice of proposed 
rulemaking have been submitted to the Office of Management and Budget 
for review in accordance with the Paperwork Reduction Act of 1995 (44 
U.S.C. 3507(d)). Comments on the collections of information should be 
sent to the Office of Management and Budget, Attn: Desk Officer for the 
Department of Treasury, Office of Information and Regulatory Affairs, 
Washington, DC 20503, with copies to the Internal Revenue Service, 
Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 
20224. Comments on the collections of information should be received by 
October 5, 2007. Comments are specifically requested concerning:
    Whether the proposed collections of information are necessary for 
the proper performance of the functions of the Internal Revenue 
Service, including whether the information will have practical utility;
    The accuracy of the estimated burden associated with the proposed 
collection of information;
    How the quality, utility, and clarity of the information to be 
collected may be enhanced;
    How the burden of complying with the proposed collections of 
information may be minimized, including through the application of 
automatic collection techniques or other forms of information 
technology; and
    Estimates of the capital or start-up costs and costs of operation, 
maintenance, and purchase of service to provide information.
    The collection of information in this proposed regulation is in 
Sec.  1.125-2 (cafeteria plan elections); Sec.  1.125-6(b)-(g) 
(substantiation of expenses), and Sec.  1.125-7 (cafeteria plan 
nondiscrimination rules). This information is required to file 
employment tax returns and Forms W-2. The collection of information is 
voluntary to obtain a benefit. The likely respondents are Federal, 
state or local governments, business or other for-profit institutions, 
nonprofit institutions, and small businesses or organizations.
    Estimated total annual reporting burden: 34,000,000 hours.
    Estimated average annual burden per respondent: 5 hours.
    Estimated annual frequency of responses: once.
    An agency may not conduct or sponsor, and a person is not required 
to respond to, a collection of information unless it displays a valid 
control number assigned by the Office of Management and Budget.
    Books or records relating to a collection of information must be 
retained as long as their contents may become material in the 
administration of any internal revenue law. Generally, tax returns and 
tax return information are confidential, as required by 26 U.S.C. 6103.

Background

    This document contains proposed Income Tax Regulations (26 CFR Part 
1) under section 125 of the Internal Revenue Code (Code). On May 7, 
1984, December 31, 1984, March 7, 1989, November 7, 1997, and March 23, 
2000, the IRS and Treasury Department published proposed amendments to 
26 CFR Part 1 under section 125 in the Federal Register (49 FR 19321, 
49 FR 50733, 54 FR 9460, 62 FR 60196 and 65 FR 15587). These 1984, 
1989, 1997 and 2000 proposed regulations are hereby withdrawn. Also, 
the temporary regulations under section 125 that were published on 
February 4, 1986 in the Federal Register (51 FR 4318) are being 
withdrawn in a separate document. The new proposed regulations that are 
published in this document replace those proposed regulations.

Explanation of Provisions

    Overview
    The new proposed regulations are organized as follows: general 
rules on qualified and nonqualified benefits in cafeteria plans (new 
proposed Sec.  1.125-1), general rules on elections (new proposed Sec.  
1.125-2), general rules on flexible spending arrangements (new proposed 
Sec.  1.125-5), general rules on substantiation of expenses for 
qualified benefits (new proposed Sec.  1.125-6) and nondiscrimination 
rules (new proposed Sec.  1.125-7). The new proposed regulations, new 
Proposed Sec. Sec.  1.125-1, 1.125-2, 1.125-5, 1.125-6 and Sec.  1.125-
7, consolidate and restate Proposed Sec.  1.125-1 (1984, 1997, 2000), 
Sec.  1.125-2 (1989, 1997, 2000) and Sec.  1.125-2T (1986). Unless 
otherwise indicated, references to ``new proposed regulations'' or 
``these proposed regulations'' mean the proposed section 125 
regulations being published in this document.
    The new proposed regulations reflect changes in tax law since the 
prior regulations were proposed, including: the change in the 
definition of dependent (section 152) and the addition of the following 
as qualified benefits: adoption assistance (section 137), additional 
deferred compensation benefits described in section 125(d)(1)(B), (C) 
and (D), Health Savings

[[Page 43939]]

Accounts (HSAs) (sections 223, 125(d)(2)(D) and 4980G), and qualified 
HSA distributions from health FSAs (section 106(e)). Other changes 
include the prohibition against long-term care insurance and long-term 
care services (section 125(f)) and the addition of the key employee 
concentration test in section 125(b)(2).
    The prior proposed regulations, Sec. Sec.  1.125-1 and 1.125-2, 
provide the basic framework and requirements for cafeteria plans and 
elections under cafeteria plans. The prior proposed regulations also 
outlined the most significant rules for benefits under a health 
flexible spending arrangement (health FSA) offered by a cafeteria 
plan--the requirement that the maximum reimbursement be available at 
all times during the coverage period (the uniform coverage rule), the 
requirement of a 12-month period of coverage, the requirement that the 
health FSA only reimburse medical expenses, the requirement that all 
medical expenses be substantiated by a third party before 
reimbursement, the requirement that expenses be incurred during the 
period of coverage, and the prohibition against deferral of 
compensation (including the use-or-lose rule). The prior proposed 
regulations also provided guidelines for dependent care FSAs, and the 
application of section 125 to paid vacation days offered under a 
cafeteria plan. These remain substantially unchanged in the new 
proposed regulations, with certain clarifications. Finally, the prior 
proposed regulations included a number of Q & As addressing 
transitional issues relating to the enactment of section 125, as well 
as the application of the now-repealed section 89 (special 
nondiscrimination rules with respect to certain employee benefit 
plans). These provisions are omitted from the new proposed regulations.
I. New Proposed Sec.  1.125-1--Qualified and Nonqualified Benefits in 
Cafeteria Plans Section 125 Exclusive Noninclusion Rule
    Section 125 provides that, except in the case of certain 
discriminatory benefits, no amount shall be included in the gross 
income of a participant in a cafeteria plan (as defined in section 
125(d)) solely because, under the plan, the participant may choose 
among the benefits of the plan. The new proposed regulations clarify 
and amplify the general rule in the prior proposed regulations that 
section 125 is the exclusive means by which an employer can offer 
employees a choice between taxable and nontaxable benefits without the 
choice itself resulting in inclusion in gross income by the employees. 
When employees may elect between taxable and nontaxable benefits, this 
election results in gross income to employees, unless a specific 
Internal Revenue Code (Code) section (such as section 125) intervenes 
to prevent gross income inclusion. Thus, except for an election made 
through a cafeteria plan that satisfies section 125 or another specific 
Code section (such as section 132(f)(4)), any opportunity to elect 
among taxable and nontaxable benefits results in inclusion of the 
taxable benefit regardless of what benefit is elected and when the 
election is made. This interpretation of section 125 is consistent with 
the legislative history of section 125. The legislative history begins 
with the interim ERISA rules for cafeteria plans:

    Under * * * ERISA, an employer contribution made before January 
1, 1977, to a cafeteria plan in existence on June 27, 1974, is 
required to be included in an employees' gross income only to the 
extent that the employee actually elects taxable benefits. In the 
case of a plan not in existence on June 27, 1974, the employer 
contribution is required to be included in an employee's gross 
income to the extent the employee could have elected taxable 
benefits. S. Rep. No. 1263, 95th Cong., 2d Sess. 74 (1978), 
reprinted in 1978 U.S.C.C.A.N. 6837; H. R. Rep. No. 1445, 95th 
Cong., 2d Sess. 63 (1978); H.R. Conf. Rep. No. 1800, 95th Cong., 2d 
Sess. 206 (1978).

    The legislative history also provides:

    [G]enerally, employer contributions under a written cafeteria 
plan which permits employees to elect between taxable and nontaxable 
benefits are excluded from the gross income of an employee to the 
extent that nontaxable benefits are elected. S. Rep. No. 1263, 95th 
Cong., 2d Sess. 75 (1978), reprinted in 1978 U.S.C.C.A.N. 6838; H. 
R. Rep. No. 1445, 95th Cong., 2d Sess. 63 (1978). See also H.R. 
Conf. Rep. No. 1800, 95th Cong., 2d Sess. 206 (1978).

    The legislative history to the 1984 amendments to section 125 
continues:

    The cafeteria plan rules of the Code provide that a participant 
in a nondiscriminatory cafeteria plan will not be treated as having 
received a taxable benefit offered under the plan solely because the 
participant has the opportunity, before the benefit becomes 
available, to choose among the taxable and nontaxable benefits under 
the plan.
    H.R. Conf. Rep. No. 861, 98th Cong., 2d Sess. 1173 (1984), 
reprinted in 1984 U.S.C.C.A.N. 1861. See also H.R. Conf. Rep. No. 
736, 104th Cong., 2d Sess. 295, reprinted in 1996 U.S.C.C.A.N. 2108.

    The new proposed regulations provide that unless a plan satisfies 
the requirements of section 125 and the regulations, the plan is not a 
cafeteria plan. Reasons that a plan would fail to satisfy the section 
125 requirements include: Offering nonqualified benefits; not offering 
an election between at least one permitted taxable benefit and at least 
one qualified benefit; deferring compensation; failing to comply with 
the uniform coverage rule or use-or-lose rule; allowing employees to 
revoke elections or make new elections during a plan year, except as 
provided in Sec.  1.125-4; failing to comply with substantiation 
requirements; paying or reimbursing expenses incurred for qualified 
benefits before the effective date of the cafeteria plan or before a 
period of coverage; allocating experience gains (forfeitures) other 
than as expressly allowed in the new proposed regulations; and failing 
to comply with grace period rules.

Definition of a Cafeteria Plan

    The new proposed regulations provide that a cafeteria plan is a 
separate written plan that complies with the requirements of section 
125 and the regulations, that is maintained by an employer for 
employees and that is operated in compliance with the requirements of 
section 125 and the regulations. Participants in a cafeteria plan must 
be permitted to choose among at least one permitted taxable benefit 
(for example, cash, including salary reduction) and at least one 
qualified benefit. A plan offering only elections among nontaxable 
benefits is not a cafeteria plan. Also, a plan offering only elections 
among taxable benefits is not a cafeteria plan. See Rev. Rul. 2002-27, 
Situation 2 (2002-1 CB 925), see Sec.  601.601(d)(2)(ii)(b). Finally, a 
cafeteria plan must not provide for deferral of compensation, except as 
specifically permitted in section 125(d)(2)(B), (C), or (D).

Written Plan

    Section 125(d)(1) requires that a cafeteria plan be in writing. The 
cafeteria plan must be operated in accordance with the written plan 
terms. The new proposed regulations require that the written plan 
specifically describe all benefits, set forth the rules for eligibility 
to participate and the procedure for making elections, provide that all 
elections are irrevocable (except to the extent that the plan includes 
the optional change in status rules in Sec.  1.125-4), and state how 
employer contributions may be made under the plan (for example, salary 
reduction or nonelective employer contributions), the maximum amount of 
elective contributions, and the plan year. If the plan includes a 
flexible spending arrangement (FSA), the written plan must include 
provisions complying

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with the uniform coverage rule and the use-or-lose rule. Because 
section 125(d)(1)(A) states that a cafeteria plan is a written plan 
under which ``all participants are employees,'' the new proposed 
regulations require that the written cafeteria plan specify that only 
employees may participate in the cafeteria plan. The new proposed 
regulations also require that all provisions of the written plan apply 
uniformly to all participants.

Individuals Who May Participate in a Cafeteria Plan

    All participants in a cafeteria plan must be employees. See section 
125(d)(1)(A). These proposed regulations provide that employees include 
common law employees, leased employees described in section 414(n), and 
full-time life insurance salesmen (as defined in section 7701(a)(20)). 
These proposed regulations further provide that former employees 
(including laid-off employees and retired employees) may participate in 
a plan, but a plan may not be maintained predominantly for former 
employees. See Rev. Rul. 82-196 (1982-2 CB 53); Rev. Rul. 85-121 (1985-
2 CB 57), see Sec.  601.601(d)(2)(ii)(b). All employees who are treated 
as employed by a single employer under section 414(b), (c) or (m) are 
treated as employed by a single employer for purposes of section 125. 
See section 125(g)(4). A participant's spouse or dependents may receive 
benefits through a cafeteria plan although they cannot participate in 
the cafeteria plan.
    Self-employed individuals are not treated as employees for purposes 
of section 125. Accordingly, the new proposed regulations make clear 
that sole proprietors, partners, and directors of corporations are not 
employees and may not participate in a cafeteria plan. In addition, the 
new proposed regulations clarify that 2-percent shareholders of an S 
corporation are not employees for purposes of section 125. The new 
proposed regulations provide rules for dual status individuals and 
individuals moving between employee and non-employee status. A self-
employed individual may, however, sponsor a cafeteria plan for his or 
her employees.

Election Between Taxable and Nontaxable Benefits

    The new proposed regulations require that a cafeteria plan offer 
employees an election among only permitted taxable benefits (including 
cash) and qualified nontaxable benefits. See section 125(d)(1)(B). For 
purposes of section 125, cash means cash from current compensation 
(including salary reduction), payment for annual leave, sick leave, or 
other paid time off, severance pay, property, and certain after-tax 
employee contributions. Distributions from qualified retirement plans 
are not cash or taxable benefits for purposes of section 125. See Rev. 
Rul. 2003-62 (2003-1 CB 1034) (distributions to former employees from a 
qualified employees' trust, applied to pay health insurance premiums, 
are includible in former employees' gross income under section 402), 
see Sec.  601.601(d)(2)(ii)(b).

Qualified Benefits

    In general, in order for a benefit to be a qualified benefit for 
purposes of section 125, the benefit must be excludible from employees' 
gross income under a specific provision of the Code and must not defer 
compensation, except as specifically allowed in section 125(d)(2)(B), 
(C) or (D). Examples of qualified benefits include the following: 
group-term life insurance on the life of an employee (section 79); 
employer-provided accident and health plans, including health flexible 
spending arrangements, and accidental death and dismemberment policies 
(sections 106 and 105(b)); a dependent care assistance program (section 
129); an adoption assistance program (section 137); contributions to a 
section 401(k) plan; contributions to certain plans maintained by 
educational organizations, and contributions to HSAs. Section 125(f), 
(d)(2)(B), (C), (D). See Notice 97-9 (1997-2 CB 35) (adoption 
assistance), see Sec.  601.601(d)(2)(ii)(b); Notice 2004-2, Q & A-33 
(2004-1 CB 269) (HSAs), see Sec.  601.601(d)(2)(ii)(b). A cafeteria 
plan may also offer long-term and short-term disability coverage as a 
qualified benefit (see section 106). However, see paragraph (q) in 
Sec.  1.125-1 for nonqualified benefits.

Group-Term Life Insurance

    An employer may provide group-term life insurance through a 
combination of methods. Generally, under section 79(a), the cost of 
$50,000 or less of group-term life insurance on the life of an employee 
provided under a policy (or policies) carried directly or indirectly by 
an employer is excludible from the employee's gross income. (Special 
rules apply to key employees if the group-term life insurance plan does 
not satisfy the nondiscrimination rules in section 79(d)). However, if 
the group-term life insurance provided to an employee by an employer or 
employers exceeds $50,000 (taking into account all coverage provided 
both through a cafeteria plan and outside a cafeteria plan), the cost 
of coverage exceeding coverage of $50,000 is includible in the 
employee's gross income. For this purpose, the cost of group-term life 
insurance is shown in Sec.  1.79-3(d)(2), Table I (Table I). The Table 
I cost of the excess group-term life insurance (minus all after-tax 
contributions by the employee for group-term life insurance coverage) 
is includible in each covered employee's gross income. The new proposed 
regulations provide that the cost of group-term life insurance on the 
life of an employee, that either is less than or equal to the amount 
excludible from gross income under section 79(a) or provides coverage 
in excess of that amount, but not combined with any permanent benefit, 
is a qualified benefit that may be offered in a cafeteria plan. The new 
proposed regulations also provide that the entire amount of salary 
reduction and employer flex-credits for group-term life insurance 
coverage on the life of an employee is excludible from an employee's 
gross income.
    The rule in the new proposed regulations differs from Notice 89-110 
(1989-2 CB 447), see Sec.  601.601(d)(2)(ii)(b). Notice 89-110 provides 
that an employee includes in gross income the greater of the Table I 
cost of group-term life insurance coverage exceeding $50,000 or the 
employee's salary reduction and employer flex-credits for excess group-
term life insurance coverage. The new proposed regulations provide 
instead that the employee includes in gross income the Table I cost of 
the excess coverage (minus all after-tax contributions by the employee 
for group-term life insurance coverage) and that the entire amount of 
salary reduction and employer flex-credits for group-term life 
insurance coverage on the life of the employee is excludible from the 
employee's gross income. As noted in this preamble, taxpayers may rely 
on the new proposed regulations for guidance pending the issuance of 
final regulations.

Employer-Provided Accident and Health Plan

    Coverage under an employer-provided accident and health plan that 
satisfies the requirements of section 105(b) may be provided as a 
qualified benefit through a cafeteria plan and is excludible from 
employees' gross income. Section 106; Sec.  1.106-1. The 
nondiscrimination rules under section 105(h) apply to self-insured 
medical reimbursement arrangements (including health FSAs).
    The new proposed regulations specifically permit a cafeteria plan 
(but

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not a health FSA) to pay or reimburse substantiated individual accident 
and health insurance premiums. See Rev. Rul. 61-146 (1961-2 CB 25), see 
Sec.  601.601(d)(2)(ii)(b). In addition, a cafeteria plan may provide 
for payment of COBRA premiums for an employee.
    For employer-provided accident and health plans and medical 
reimbursement plans, the definition of dependents is the definition in 
section 105(b) as amended by the Working Families Tax Relief Act of 
2004 (WFTRA), Public Law 108-311, section 207(9) (118 Stat. 1166) (that 
is, a dependent as defined in section 152, determined without regard to 
section 152(b)(1), (b)(2), or (d)(1)(B)). See Notice 2004-79 (2004-2 CB 
898), see Sec.  601.601(d)(2)(ii)(b). For purposes of the exclusion 
from employees' gross income for accident and health plans and for 
medical reimbursement under sections 105(b) and 106, the spouse or 
dependent of a former employee (including a retired employee or a laid-
off employee) or of a deceased employee is treated as a spouse or 
dependent. See Rev. Rul. 82-196 (1982-2 CB 53); Rev. Rul. 85-121 (1985-
2 CB 57), see Sec.  601.601(d)(2)(ii)(b).

Dependent Care Assistance Programs and Adoption Assistance Programs

    If the requirements of section 129 are satisfied, up to $5,000 of 
employer-provided assistance for amounts paid or incurred by employees 
for dependent care is excludible from employees' gross income. The new 
proposed regulations outline the general requirements for providing 
dependent care assistance programs and adoption assistance programs 
under section 137 through a cafeteria plan. See Notice 97-9, section II 
(1997-2 CB 35), see Sec.  601.601(d)(2)(ii)(b).

Cafeteria Plan Year

    The new proposed regulations require that a cafeteria plan year 
must be 12 consecutive months and must be set out in the written 
cafeteria plan. A short plan year (or a change in plan year resulting 
in a short plan year) is permitted only for a valid business purpose. A 
change in plan year resulting in a short plan year, for other than a 
valid business purpose, is disregarded. If a principal purpose of a 
change in plan year is to circumvent the rules of section 125, the 
change in plan year is ineffective.

No Deferral of Compensation

    Qualified benefits must be current benefits. In general, a 
cafeteria plan may not offer benefits that defer compensation or 
operate to defer compensation. Section 125(d)(2)(A). In general, 
benefits may not be carried over to a later plan year or used in one 
plan year to purchase benefits to be provided in a later plan year. For 
example, life insurance with a cash value build-up or group-term life 
insurance with a permanent benefit (within the meaning of Sec.  1.79-0) 
defers the receipt of compensation and thus is not a qualified benefit.
    The new proposed regulations clarify whether certain benefits and 
plan administration practices defer compensation. For example, the 
regulations permit an accident and health insurance policy to provide 
certain benefit features that apply for more than one plan year, such 
as reasonable lifetime limits on benefits, level premiums, premium 
waiver during disability, guaranteed renewability of coverage, coverage 
for specified accidental injury or specific diseases, and the payment 
of a fixed amount per day for hospitalization. But these insurance 
policies must not provide an investment fund or cash value to pay 
premiums, and no part of the premium may be held in a separate account 
for any beneficiary. The new proposed regulations also provide that the 
following benefits and practices do not defer compensation: a long-term 
disability policy paying benefits over more than one plan year; 
reasonable premium rebates or policy dividends; certain two-year lock-
in vision and dental policies; certain advance payments for 
orthodontia; salary reduction contributions in the last month of a plan 
year used to pay accident and health insurance premiums for the first 
month of the following plan year; reimbursement of section 213(d) 
expenses for durable medical equipment; and allocation of experience 
gains (forfeitures) among participants.

Paid Time Off

    Under the prior proposed regulations, permitted taxable benefits 
included various forms of paid leave. Since the prior proposed 
regulations were issued, many employers have recharacterized and 
combined vacation days, sick leave and personal days into a single 
category of ``paid time off.'' The new proposed regulations use the 
term ``paid time off'' to refer to vacation days and other types of 
paid leave. The new proposed regulations contain the same ordering rule 
for elective and nonelective paid time off as set forth in Prop. Sec.  
1.125-1, Q & A-7 (1984). A plan offering an election solely between 
paid time off and taxable benefits is not a cafeteria plan.

Grace Period

    The new proposed regulations allow a written cafeteria plan to 
provide an optional grace period immediately following the end of each 
plan year, extending the period for incurring expenses for qualified 
benefits. A grace period may apply to one or more qualified benefits 
(for example, health FSA or dependent care assistance program) but in 
no event does it apply to paid time off or contributions to section 
401(k) plans. Unused benefits or contributions for one qualified 
benefit may only be used to reimburse expenses incurred during the 
grace period for that same qualified benefit. The amount of unused 
benefits and contributions available during the grace period may be 
limited by the employer. A grace period may extend to the fifteenth day 
of the third month after the end of the plan year (but may be for a 
shorter period). Benefits or contributions not used as of the end of 
the grace period are forfeited under the use-or-lose rule. The grace 
period applies to all employees who are participants (including through 
COBRA), as of the last day of the plan year. Grace period rules must 
apply uniformly to all participants. The grace period rules in these 
proposed regulations are based on Notice 2005-42 (2005-1 CB 1204), 
modified in Notice 2007-22 (2007-10 IRB 670), see Sec.  
601.601(d)(2)(ii)(b), amplified in Notice 2005-86 (2005-2 CB 1075), 
amplified in Notice 2007-22 (2007-10 IRB 670), see Sec.  
601.601(d)(2)(ii)(b). For eligibility to contribute to a Health Savings 
Account (HSA) during a grace period, see Notice 2005-86 (2005-2 CB 
1075), see Sec.  601.601(d)(2)(ii)(b). For Form W-2 reporting for 
unused dependent care assistance used for expenses incurred during a 
grace period, see Notice 2005-61 (2005-2 CB 607), see Sec.  
601.601(d)(2)(ii)(b).

Contributions to Section 401(k) Plans Through a Cafeteria Plan

    A cafeteria plan may include contributions to a section 401(k) 
plan. Section 125(d)(2)(B). The new proposed regulations clarify the 
interactions between section 125 and section 401(k). Contributions to a 
section 401(k) plan expressed as a percentage of compensation are 
permitted. Pursuant to Sec.  1.401(k)-1(a)(3)(ii), elective 
contributions to a section 401(k) plan may be made through automatic 
enrollment (that is, when the employee does not affirmatively elect 
cash, the employee's compensation is reduced by a fixed percentage, 
which is contributed to a section 401(k) plan).

[[Page 43942]]

Nonqualified Benefits

    A cafeteria plan must not offer any of the following benefits: 
scholarships (section 117); employer-provided meals and lodging 
(section 119); educational assistance (section 127); fringe benefits 
(section 132); long-term care insurance. See section 125(f). Long-term 
care services are nonqualified benefits, H.R. Conf. Rep. No. 736, 104th 
Cong., 2d Sess. 29, reprinted in 1996 U.S.C.C.A.N. 2109. (An HSA funded 
through a cafeteria plan may, however, be used to pay premiums for 
long-term care insurance or for long-term care services.) The new 
proposed regulations clarify that contributions to Archer Medical 
Savings Accounts (sections 220, 106(b)), group term life insurance for 
an employee's spouse, child or dependent, and elective deferrals to 
section 403(b) plans are also nonqualified benefits. A plan offering 
any nonqualified benefit is not a cafeteria plan. A cafeteria plan may 
not offer a health FSA that provides for the carryover of unused 
benefits. See Notice 2002-45, Part I (2002-2 CB 93); Rev. Rul. 2002-41 
(2002-2 CB 75), see Sec.  601.601(d)(2)(ii)(b).

After-Tax Employee Contributions

    The new proposed regulations allow a cafeteria plan to offer after-
tax employee contributions for qualified benefits or paid time off. A 
cafeteria plan may only offer the taxable benefits specifically 
permitted in the new proposed regulations. Nonqualified benefits may 
not be offered through a cafeteria plan, even if paid with after-tax 
employee contributions.

Employer Contributions Through Salary Reduction

    Employees electing a qualified benefit through salary reduction are 
electing to forego salary and instead to receive a benefit which is 
excludible from gross income because it is provided by employer 
contributions. Section 125 provides that the employee is treated as 
receiving the qualified benefit from the employer in lieu of the 
taxable benefit. A cafeteria plan may also impose reasonable fees to 
administer the cafeteria plan which may be paid through salary 
reduction. A cafeteria plan is not required to allow employees to pay 
for any qualified benefit with after-tax employee contributions.

II. New Prop. Sec.  1.125-2--Elections in Cafeteria Plans

Making, Revoking and Changing Elections

    Generally, a cafeteria plan must require employees to elect 
annually between taxable benefits and qualified benefits. Elections 
must be made before the earlier of the first day of the period of 
coverage or when benefits are first currently available. The 
determination of whether a taxable benefit is currently available does 
not depend on whether it has been constructively received by the 
employee for purposes of section 451. Annual elections generally must 
be irrevocable and may not be changed during the plan year. However, 
Sec.  1.125-4 permits a cafeteria plan to provide for changes in 
elections based on certain changes in status. An employer that wishes 
to permit such changes in elections must incorporate the rules in Sec.  
1.125-4 in its written cafeteria plan. These proposed regulations omit 
the rule in Q & A-6(b) in Prop. Sec.  1.125-2 (1989) (cessation of 
required contributions), because the change in status rules in Sec.  
1.125-4 superseded this provision of the 1989 proposed regulations.
    If HSA contributions are made through salary reduction under a 
cafeteria plan, employees may prospectively elect, revoke or change 
salary reduction elections for HSA contributions at any time during the 
plan year with respect to salary that has not become currently 
available at the time of the election.
    A cafeteria plan is permitted to include an automatic election for 
new employees or current employees. Rev. Rul. 2002-27 (2002-1 CB 925), 
see Sec.  601.601(d)(2)(ii)(b). A new rule also permits a cafeteria 
plan to provide an optional election for new employees between cash and 
qualified benefits. New employees avoid gross income inclusion if they 
make an election within 30 days after the date of hire even if benefits 
provided pursuant to the election relate back to the date of hire. 
However, salary reduction amounts used to pay for such an election must 
be from compensation not yet currently available on the date of the 
election. Also, this special election rule for new employees does not 
apply to any employee who terminates employment and is rehired within 
30 days after terminating employment (or who returns to employment 
following an unpaid leave of absence of less than 30 days).
    New elections and revocations or changes in elections can be made 
electronically. The safe harbor for electronic elections in Sec.  
1.401(a)-21 is available. Only an employee can make an election or 
revoke or change his or her election. An employee's spouse or dependent 
may not make an election under a cafeteria plan and may not revoke or 
change an employee's election.

III. New Prop. Sec.  1.125-5--Flexible Spending Arrangements

Overview

    In general, a flexible spending arrangement (FSA) is a benefit 
designed to reimburse employees for expenses incurred for certain 
qualified benefits, up to a maximum amount not substantially in excess 
of the salary reduction and employer flex-credits allocated for the 
benefit. The maximum amount of reimbursement reasonably available must 
be less than five times the value of the coverage. Employer flex-
credits are non-elective employer contributions that an employer makes 
available for every employee eligible to participate in the cafeteria 
plan, to be used at the employee's election only for one or more 
qualified benefits (but not as cash or other taxable benefits). The 
three types of FSAs are dependent care assistance, adoption assistance 
and medical care reimbursements (health FSA).

Uniform Coverage Rule

    The new proposed regulations retain the rule that the maximum 
amount of reimbursement from a health FSA must be available at all 
times during the period of coverage (properly reduced as of any 
particular time for prior reimbursements). The uniform coverage rule 
does not apply to FSAs for dependent care assistance or adoption 
assistance.

Use-or-Lose Rule

    An FSA must satisfy all the requirements of section 125, including 
the prohibition against deferring compensation. In general, as 
discussed under ``No deferral of compensation'', in order to satisfy 
this requirement of section 125, all benefits and contributions must be 
used by the end of the plan year (or grace period, if applicable), or 
are forfeited. The new proposed regulations continue the use-or-lose 
rule.

Period of Coverage

    The required period of coverage for all FSAs continues to be twelve 
months, with an exception for short plan years that satisfy the 
conditions in the new proposed regulations. The period of coverage and 
the plan year need not be the same. The beginning and end of a period 
of coverage is clarified. The new proposed regulations also clarify 
that FSAs for different qualified benefits need not have the same 
coverage period. See also ``Grace period'', discussed in this preamble. 
The new proposed

[[Page 43943]]

regulations also continue to provide that expenses are incurred when 
services are provided. Expenses incurred before or after the period of 
coverage may not be reimbursed.

Health FSA

    A health FSA may only reimburse certain substantiated section 
213(d) medical care expenses incurred by the employee, or by the 
employee's spouse or dependents. A health FSA may be limited to a 
subset of permitted section 213(d) medical expenses (for example, a 
health FSA is permitted to exclude reimbursement of over-the-counter 
drugs described in Rev. Rul. 2003-102 (2003-2 CB 559), see Sec.  
601.601(d)(2)(ii)(b)). Similarly, a health FSA may be an HSA-compatible 
limited-purpose health FSA or post-deductible health FSA. Rev. Rul. 
2004-45 (2004-1 CB 971), see Sec.  601.601(d)(2)(ii)(b), amplified, 
Notice 2005-86 (2005-2 CB 1075). A health FSA may not reimburse 
premiums for accident and health insurance or long-term care insurance. 
See section 125(f).
    A health FSA must satisfy all requirements of section 105(b), 
Sec. Sec.  1.105-1 and 1.105-2. The section 105(h) nondiscrimination 
rules apply to health FSAs. All medical expenses must be substantiated 
before expenses are reimbursed. See Incurring and reimbursing expenses 
for qualified benefits, discussed in this preamble. The new proposed 
regulations also clarify when medical expenses are incurred.\1\ A 
cafeteria plan may limit enrollment in a health FSA to those employees 
who participate in the employer's accident and health plan.
---------------------------------------------------------------------------

    \1\ See Rev. Rul. 2005-55 (2005-2 CB 284) and Rev. Rul. 2005-24 
(2005-1 CB 892), see Sec.  601.601(d)(2)(ii)(b) (section 105(b) 
exclusion only applicable to reimbursements for medical expenses 
incurred by employee, or by the employee's spouse or dependents); 
Rev. Rul. 2002-3 (2002-1 CB 316) (purported reimbursements to 
employees of health insurance premiums not paid by employees and 
therefore impermissible); Rev. Rul. 2002-80 (2002-2 CB 925), see 
Sec.  601.601(d)(2)(ii)(b) (so-called advance reimbursements and 
purported loans are impermissible); Rev. Rul. 2003-43 (2003-1 CB 
935), see Sec.  601.601(d)(2)(ii)(b); Notice 2006-69 (2006-31 IRB 
107) (substantiation requirements for debit cards), amplified in 
Notice 2007-2 (2007-2 IRB 254), see Sec.  601.601(d)(2)(ii)(b).
---------------------------------------------------------------------------

Qualified HSA Distributions

    Section 106(e), enacted in section 302 of the Health Opportunity 
Patient Empowerment Act of 2006, Public Law 109-432 (120 Stat. 2922 
(2006)) allows ``qualified HSA distributions'' from health FSAs to 
HSAs. Section 106(e) applies to distributions between December 20, 2006 
and December 31, 2011. The proposed regulations incorporate the rules 
on qualified HSA distributions set forth in Notice 2007-22 (2007-10 IRB 
670). See Sec.  601.601(d)(2)(ii)(b).

Dependent Care Assistance After Termination

    A new optional rule permits an employer to reimburse a terminated 
employee's qualified dependent care expenses incurred after termination 
through a dependent care FSA, if all section 129 requirements are 
otherwise satisfied.

Experience Gains

    If an employee fails to use all contributions and benefits for a 
plan year before the end of the plan year (and the grace period, if 
applicable), those unused contributions and benefits are forfeited 
under the use-or-lose rule. Unused amounts are also known as experience 
gains. The new proposed regulations retain the forfeiture allocation 
rules in the 1989 proposed regulations, and clarify that the employer 
sponsoring the cafeteria plan may retain forfeitures, use forfeitures 
to defray expenses of administering the plan or allocate forfeitures 
among employees contributing through salary reduction on a reasonable 
and uniform basis.

FSA Administrative Rules

    Salary reduction contributions may be made at whatever interval the 
employer selects, including ratably over the plan year based on the 
employer's payroll periods or in equal installments at other regular 
intervals (for example, quarterly installments). These rules must apply 
uniformly to all participants.

IV. New Prop. Sec.  1.125-6--Substantiation of Expenses for All 
Cafeteria Plans

Incurring and Reimbursing Expenses for Qualified Benefits

    The new proposed regulations provide that only expenses for 
qualified benefits incurred after the later of the effective date or 
the adoption date of the cafeteria plan are permitted to be reimbursed 
under the cafeteria plan. Similarly, if a plan amendment adds a new 
qualified benefit, only expenses incurred after the later of the 
effective date or the adoption date are eligible for reimbursement.\2\ 
This rule applies to all qualified benefits. Similarly, a cafeteria 
plan may pay or reimburse only expenses for qualified benefits incurred 
during a participant's period of coverage.
---------------------------------------------------------------------------

    \2\ See American Family Mut. Ins. Co. v. United States, 815 F. 
Supp. 1206 (W.D. Wis. 1992); Wollenberg v. United States, 75 F. 
Supp.2d 1032 (D. Neb. 1999); Rev. Rul. 2002-58 (2002-2 CB 541), see 
Sec.  601.601(d)(2)(ii)(b); Notice 97-9, section II (adoption 
assistance).
---------------------------------------------------------------------------

Substantiation and Reimbursement of Expenses for Qualified Benefits

    The new proposed regulations provide, after an employee incurs an 
expense for a qualified benefit during the coverage period, the expense 
must first be substantiated before the expense may be paid or 
reimbursed. All expenses must be substantiated (substantiating only a 
limited number of total claims, or not substantiating claims below a 
certain dollar amount does not satisfy the requirements in the new 
proposed regulations). See Sec.  1.105-2; Rul. 2003-80; Rev. Rul. 2003-
43 (2002-1 CB 935), see Sec.  601.601(d)(2)(ii)(b); Notice 2006-69 
(2006-31 IRB 107), Notice 2007-2 (2007-2 IRB 254). FSAs for dependent 
care assistance and adoption assistance must follow the substantiation 
procedures applicable to health FSAs.

Debit Cards

    The new proposed regulations incorporate previously issued guidance 
on substantiating, paying and reimbursing expenses for section 213(d) 
medical care incurred at a medical care provider when payment is made 
with a debit card. Rev. Rul. 2003-43 (2003-1 CB 935), amplified, Notice 
2006-69 (2006-31 IRB 107), Notice 2007-2 (2007-2 IRB 254); Rev. Proc. 
98-25 (1998-1 CB 689), see Sec.  601.601(d)(2)(ii)(b). Among the 
permissible substantiation methods are copayment matches, recurring 
expenses, and real-time substantiation. The new proposed regulations 
also allow point-of-sale substantiation through matching inventory 
information with a list of section 213(d) medical expenses. The 
employer is responsible for ensuring that the inventory information 
approval system complies with the new regulations and with the 
recordkeeping requirements in section 6001. Rev. Rul. 2003-43 (2003-1 
CB 935), amplified, Notice 2006-69 (2006-31 IRB 107), Notice 2007-2 
(2007-2 IRB 254); Rev. Proc. 98-25 (1998-1 CB 689), see Sec.  
601.601(d)(2)(ii)(b). The new proposed regulations also provide rules 
under which an FSA may pay or reimburse dependent care expenses using 
debit cards.
    Pursuant to prior guidance (in Notice 2006-69 (2006-31 IRB 107), 
amplified, Notice 2007-2 (2007-2 IRB 254)), for plan years beginning 
after December 31, 2006, the recordkeeping requirements described in 
paragraph (f) in Sec.  1.125-6 apply (that is, responsibility of 
employers relying on the inventory information approval system for 
health

[[Page 43944]]

FSA debit cards to ensure that the system complies with the new 
proposed recordkeeping requirements, including Rev. Proc. 98-25 (1998-1 
CB 689), Notice 2006-69 (2006-31 IRB 107), amplified, Notice 2007-2 
(2007-2 IRB 254). For health FSA debit card transactions occurring on 
or before December 31, 2007, all supermarkets, grocery stores, discount 
stores and wholesale clubs that do not have a medical care merchant 
category code (as described in Rev. Rul. 2003-43 (2003-2 CB 935) are 
nevertheless deemed to be an ``other medical provider'' as described in 
Rev. Rul. 2003-43. (For a list of merchant category codes, see Rev. 
Proc. 2004-43 (2004-2 CB 124).) During this time period, mail-order 
vendors and web-based vendors that sell prescription drugs are also 
deemed to be an ``other medical provider'' as described in Rev. Rul. 
2003-43. After December 31, 2008, health FSA debit cards may not be 
used at stores with the Drug Stores and Pharmacies merchant category 
code unless (1) the store participates in the inventory information 
approval system described in Notice 2006-69, or (2) on a store location 
by store location basis, 90 percent of the store's gross receipts 
during the prior taxable year consisted of items which qualify as 
expenses for medical care under section 213(d) (including 
nonprescription medications described in Rev. Rul. 2003-102 (2003-2 CB 
559)). Notice 2006-69 (2006-31 IRB 107), amplified, Notice 2007-2 
(2007-2 IRB 254).

V. New Prop. Sec.  1.125-7--Nondiscrimination Rules

    Discriminatory benefits provided to highly compensated participants 
and individuals and key employees are included in these employees' 
gross income. See section 125(b), (c). The new proposed regulations 
reflect changes in tax law since Prop. Sec.  1.125-1, Q & A-9 through 
13 and 19 were proposed in 1984, including the key employee 
concentration test, statutory nontaxable benefits (enacted in the 
Deficit Reduction Act of 1984 (DEFRA), Public Law 98-369, section 
531(b), (98 Stat. 881(1984)), and the change in definition of dependent 
in WFTRA.
    The new proposed regulations provide additional guidance on the 
cafeteria plan nondiscrimination rules, including definitions of key 
terms, guidance on the eligibility test and the contributions and 
benefits tests, descriptions of employees allowed to be excluded from 
testing and a safe harbor nondiscrimination test for premium-only-
plans.
    Specifically, the new proposed regulations define several key 
terms, including highly compensated individual or participant 
(consistent with the section 414(q) definition of highly compensated 
employee), officer, five percent shareholder, key employee and 
compensation. The new proposed regulations also provide guidance on the 
nondiscrimination as to eligibility requirement by incorporating some 
of the rules under section 410(b) (specifically the rules under Sec.  
1.410(b)-4(b) and (c) dealing with reasonable classification, the safe 
harbor percentage test and the unsafe harbor percentage component of 
the facts and circumstances test).
    The new proposed regulations also provide additional guidance on 
the contributions and benefits test and, unlike the prior proposed 
regulations, the new proposed regulations provide an objective test to 
determine when the actual election of benefits is discriminatory. 
Specifically, the new proposed regulations provide that a cafeteria 
plan must give each similarly situated participant a uniform 
opportunity to elect qualified benefits, and that highly compensated 
participants must not actually disproportionately elect qualified 
benefits. Finally, the new rules provide guidance on the safe harbor 
for cafeteria plans providing health benefits and create a safe harbor 
for premium-only-plans that satisfy certain requirements.
    The example in Prop. Sec.  1.125-1, Q & A-11 (1984) is deleted 
because it concerns a qualified legal services plan, which is no longer 
a qualified benefit.

Other Issues

    These proposed regulations provide guidance under section 125 (26 
U.S.C. 125). Other statutes may impose additional requirements (for 
example, the Employee Retirement Income Security Act of 1974 (ERISA) 
(29 U.S.C. 1000), the Health Insurance Portability and Accountability 
Act of 1996 (HIPAA), (sections 9801-9803); and the continuation 
coverage requirements under the Consolidated Omnibus Budget 
Reconciliation Act of 1985 (COBRA) (section 4980B).

Proposed Effective Date

    With the exceptions noted in the ``Effect on other documents'' 
section of this preamble and under the ``Debit cards'' section of the 
preamble, it is proposed that these regulations apply for plan years 
beginning on or after January 1, 2009. Taxpayers may rely on these 
regulations for guidance pending the issuance of final regulations. 
Prior published guidance on qualified benefits under sections 79, 105, 
106, 129, 137 and 223 that is affected by these proposed regulations 
remains applicable through the effective date of the final regulations 
(except as modified in ``Effect on other documents'' section of this 
preamble).

Effect on Other Documents

    Notice 89-110 (1989-2 CB 447), see Sec.  601.601(d)(2)(ii)(b), 
states that where group-term life insurance provided to an employee by 
an employer exceeds $50,000, the employee includes in gross income the 
greater of the cost of group-term life insurance shown in Sec.  1.79-
3(d)(2), Table I (Table I ) on the excess coverage or the employee's 
salary reduction and employer flex-credits for excess coverage. Notice 
89-110 is modified, effective as of the date the proposed regulations 
are published in the Federal Register.
    Published guidance under Sec.  105(b) states that if any person has 
the right to receive cash or any other taxable or nontaxable benefit 
under a health FSA other than the reimbursement of section 213(d) 
medical expenses of the employee, employee's spouse or employee's 
dependents, then all distributions made from the arrangement are 
included in the employee's gross income, even amounts paid to reimburse 
medical care. See Rev. Rul. 2006-36 (2006-36 IRB 353); Rev. Rul. 2005-
24 (2005-1 CB 892); Rev. Rul. 2003-102 (2003-2 CB 559); Notice 2002-45 
(2002-2 CB 93); Rev. Rul. 2002-41 (2002-2 CB 75); Rev. Rul. 69-141 
(1969-1 CB 48). New section 106(e) provides that a health FSA will not 
fail to satisfy the requirements of sections 105 or 106 merely because 
the plan provides for a qualified HSA distribution. Amounts rolled into 
an HSA may be used for purposes other than reimbursing the section 
213(d) medical expenses of the employee, spouse or dependents. 
Accordingly, Rev. Rul. 2006-36, Rev. Rul. 2005-24, Rev. Rul. 2003-102, 
Notice 2002-45, Rev. Rul. 2002-41, and Rev. Rul. 69-141 are modified 
with respect to qualified HSA distributions described in section 
106(e). See Notice 2007-22 (2007-10 IRB 670), see Sec.  
601.601(d)(2)(ii)(b).

Special Analyses

    It has been determined that this notice of proposed rulemaking 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 this regulation. It is hereby 
certified that the collection of information in this regulation will 
not have a significant economic impact on a substantial

[[Page 43945]]

number of small entities. This certification is based on the fact that 
the regulations will only minimally increase the burdens on small 
entities. The requirements under these regulations relating to 
maintaining a section 125 cafeteria plan are a minimal additional 
burden independent of the burdens encompassed under existing rules for 
underlying employee benefit plans, which exist whether or not the 
benefits are provided through a cafeteria plan. In addition, most small 
entities that will maintain cafeteria plans already use a third-party 
plan administrator to administer the cafeteria plan. The collection of 
information required in these regulations, which is required to comply 
with the existing substantiation requirements of sections 105, 106, 129 
and 125, and the recordkeeping requirements of section 6001, will only 
minimally increase the third-party administrator's burden with respect 
to the cafeteria plan. Therefore, an analysis under the Regulatory 
Flexibility Act (5 U.S.C. chapter 6) is not required. Pursuant to 
section 7805(f) of the Internal Revenue Code, this proposed regulation 
has been submitted to the Chief Counsel for Advocacy of the Small 
Business Administration for comment on its impact on small business.

Comments and Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written comments (a signed original 
and eight (8) copies) or electronic comments that are submitted timely 
to the IRS. The IRS and Treasury Department specifically request 
comments on the clarity of the proposed rules and how they can be made 
easier to understand. In addition, comments are requested on the 
following issues:
    1. Whether, consistent with section 125 of the Internal Revenue 
Code, multiple employers (other than members of a controlled group 
described in section 125(g)(4)) may sponsor a single cafeteria plan;
    2. Whether salary reduction contributions may be based on 
employees' tips and how that would work;
    3. For cafeteria plans adopting the change in status rules in Sec.  
1.125-4, when a participant has a change in status and changes his or 
her salary reduction amount, how should the participant's uniform 
coverage amount be computed after the change in status.
    All comments will be available for public inspection and copying.
    A public hearing has been scheduled for November 15, 2007, 
beginning at 10 a.m. in the Auditorium, Internal Revenue Service, 1111 
Constitution Avenue, NW., Washington, DC. Due to building security 
procedures, visitors must enter at the Constitution Avenue entrance. In 
addition, all visitors must present photo identification to enter the 
building. Because of access restrictions, visitors will not be admitted 
beyond the immediate entrance area more than 30 minutes before the 
hearing starts. For information about having your name placed on the 
building access list to attend the hearing, see the FOR FURTHER 
INFORMATION CONTACT section of this preamble.
    The rules of 26 CFR 601.601(a)(3) apply to the hearing. Persons who 
wish to present oral comments at the hearing must submit written or 
electronic comments and an outline of the topics to be discussed and 
the amount of time to be devoted to each topic (a signed original and 
eight (8) copies) by October 25, 2007. A period of 10 minutes will be 
allotted to each person for making comments. An agenda showing the 
scheduling of the speakers will be prepared after the deadline for 
receiving outlines has passed. Copies of the agenda will be available 
free of charge at the hearing.

Drafting Information

    The principal author of these proposed regulations is Mireille T. 
Khoury, Office of Division Counsel/Associate Chief Counsel (Tax Exempt 
and Government Entities), Internal Revenue Service. However, personnel 
from other offices of the IRS and Treasury Department participated in 
their development.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Withdrawal of Proposed Regulations

    Accordingly, under the authority of 26 U.S.C. 7805, the notice of 
proposed rulemaking (EE-16-79) that was published in the Federal 
Register on Monday, May 7, 1984 (49 FR 19321), and Monday, December 31, 
1984 (49 FR 50733), the notice of proposed rulemaking (EE-130-86) that 
was published in the Federal Register on Tuesday, March 7, 1989 (54 FR 
9460), and Friday, November 7, 1997 (62 FR 60196) and the notice of 
proposed rulemaking (REG-117162-99) that was published in the Federal 
Register on Thursday, March 23, 2000 (65 FR 15587) are withdrawn.

Proposed Amendment to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be 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. Sections 1.125-0, 1.125-1 and 1.125-2 are added to read as 
follows:


Sec.  1.125-0  Table of contents.

    This section lists captions contained in Sec. Sec.  1.125-1, 1.125-
2, 1.125-5, 1.125-6 and Sec.  1.125-7.


Sec.  1.125-1  Cafeteria plans; general rules.

(a) Definitions.
(b) General rules.
(c) Written plan requirements.
(d) Plan year requirements.
(e) Grace period.
(f) Run-out period.
(g) Employee for purpose of Section 125.
(h) After-tax employee contributions.
(i) Prohibited taxable benefits.
(j) Coordination with other rules.
(k) Group-term life insurance.
(l) COBRA premiums.
(m) Payment or reimbursement of employees' individual accident and 
health insurance premiums.
(n) Section 105 rules for accident and health plan offered through a 
cafeteria plan.
(o) Prohibition against deferred compensation.
(p) Benefits relating to more than one year.
(q) Nonqualified benefits.
(r) Employer contributions to a cafeteria plan.
(s) Effective/applicability date.


Sec.  1.125-2  Cafeteria plans; elections.

(a) Rules relating to making elections and revoking elections.
(b) Automatic elections.
(c) Election rules for salary reduction contributions to HSAs.
(d) Optional election for new employees.
(e) Effective/applicability date.


Sec.  1.125-5  Flexible spending arrangements.

(a) Definition of flexible spending arrangement.
(b) Flex-credits allowed.
(c) Use-or-lose rule.
(d) Uniform coverage rules applicable to health FSAs.
(e) Required period of coverage for a health FSA, dependent care FSA 
and adoption assistance FSA.
(f) Coverage on a month-by-month or expense-by-expense basis 
prohibited.
(g) FSA administrative practices.
(h) Qualified benefits permitted to be offered through a FSA.
(i) Section 129 rules for dependent care assistance program offered 
through a cafeteria plan.
(j) Section 137 rules for adoption assistance program offered 
through a cafeteria plan.
(k) FSAs and the rules governing the tax-favored treatment of 
employer-provided health benefits.
(l) Section 105(h) requirements.
(m) HSA-compatible FSAs-limited-purpose health FSAs and post-
deductible health FSAs.

[[Page 43946]]

(n) Qualified HSA distributions.
(o) FSA experience gains or forfeitures.
(p) Effective/applicability date.


Sec.  1.125-6  Substantiation of expenses for all cafeteria plans.

(a) Cafeteria plan payments and reimbursements.
(b) Rules for claims substantiation for cafeteria plans.
(c) Debit cards--overview.
(d) Mandatory rules for all debit cards usable to pay or reimburse 
medical expenses.
(e) Substantiation of expenses incurred at medical care providers 
and certain other stores with Drug Stores and Pharmacies merchant 
category code.
(f) Inventory information approval system.
(g) Debit cards used to pay or reimburse dependent care assistance.
(h) Effective/applicability date.


Sec.  1.125-7  Cafeteria plan nondiscrimination rules.

(a) Definitions.
(b) Nondiscrimination as to eligibility.
(c) Nondiscrimination as to contributions and benefits.
(d) Key employees.
(e) Section 125(g)(2) safe harbor for cafeteria plans providing 
health benefits.
(f) Safe harbor test for premium-only-plans.
(g) Permissive disaggregation for nondiscrimination testing.
(h) Optional aggregation of plans for nondiscrimination testing.
(i) Employees of certain controlled groups.
(j) Time to perform nondiscrimination testing.
(k) Discrimination in actual operation prohibited.
(l) Anti-abuse rule.
(m) Tax treatment of benefits in a cafeteria plan.
(n) Employer contributions to employees' Health Savings Accounts.
(o) Effective/applicability date.


Sec.  1.125-1  Cafeteria plans; general rules.

    (a) Definitions. The definitions set forth in this paragraph (a) 
apply for purposes of section 125 and the regulations.
    (1) The term cafeteria plan means a separate written plan that 
complies with the requirements of section 125 and the regulations, that 
is maintained by an employer for the benefit of its employees and that 
is operated in compliance with the requirements of section 125 and the 
regulations. All participants in a cafeteria plan must be employees. A 
cafeteria plan must offer at least one permitted taxable benefit (as 
defined in paragraph (a)(2) of this section) and at least one qualified 
benefit (as defined in paragraph (a)(3) of this section). A cafeteria 
plan must not provide for deferral of compensation (except as 
specifically permitted in paragraph (o) of this section).
    (2) The term permitted taxable benefit means cash and certain other 
taxable benefits treated as cash for purposes of section 125. For 
purposes of section 125, cash means cash compensation (including salary 
reduction), payments for annual leave, sick leave, or other paid time 
off and severance pay. A distribution from a trust described in section 
401(a) is not cash for purposes of section 125. Other taxable benefits 
treated as cash for purposes of section 125 are:
    (i) Property;
    (ii) Benefits attributable to employer contributions that are 
currently taxable to the employee upon receipt by the employee; and
    (iii) Benefits purchased with after-tax employee contributions, as 
described in paragraph (h) of this section.
    (3) Qualified benefit. Except as otherwise provided in section 
125(f) and paragraph (q) of this section, the term qualified benefit 
means any benefit attributable to employer contributions to the extent 
that such benefit is not currently taxable to the employee by reason of 
an express provision of the Internal Revenue Code (Code) and which does 
not defer compensation (except as provided in paragraph (o) of this 
section). The following benefits are qualified benefits that may be 
offered under a cafeteria plan and are excludible from employees' gross 
income when provided in accordance with the applicable provisions of 
the Code--
    (A) Group-term life insurance on the life of an employee in an 
amount that is less than or equal to the $50,000 excludible from gross 
income under section 79(a), but not combined with any permanent benefit 
within the meaning of Sec.  1.79-0;
    (B) An accident and health plan excludible from gross income under 
section 105 or 106, including self-insured medical reimbursement plans 
(such as health FSAs described in Sec.  1.125-5);
    (C) Premiums for COBRA continuation coverage (if excludible under 
section 106) under the accident and health plan of the employer 
sponsoring the cafeteria plan or premiums for COBRA continuation 
coverage of an employee of the employer sponsoring the cafeteria plan 
under an accident and health plan sponsored by a different employer;
    (D) An accidental death and dismemberment insurance policy (section 
106);
    (E) Long-term or short-term disability coverage (section 106);
    (F) Dependent care assistance program (section 129);
    (G) Adoption assistance (section 137);
    (H) A qualified cash or deferred arrangement that is part of a 
profit-sharing plan or stock bonus plan, as described in paragraph 
(o)(3) of this section (section 401(k));
    (I) Certain plans maintained by educational organizations (section 
125(d)(2)(C) and paragraph (o)(3)(iii) of this section); and
    (J) Contributions to Health Savings Accounts (HSAs) (sections 223 
and 125(d)(2)(D)).
    (4) Dependent. The term dependent generally means a dependent as 
defined in section 152. However, the definition of dependent is 
modified to conform with the underlying Code section for the qualified 
benefit. For example, for purposes of a benefit under section 105, the 
term dependent means a dependent as defined in section 152, determined 
without regard to section 152(b)(1), (b)(2) or (d)(1)(B).
    (5) Premium-only-plan. A premium-only-plan is a cafeteria plan that 
offers as its sole benefit an election between cash (for example, 
salary) and payment of the employee share of the employer-provided 
accident and health insurance premium (excludible from the employee's 
gross income under section 106).
    (b) General rules--(1) Cafeteria plans. Section 125 is the 
exclusive means by which an employer can offer employees an election 
between taxable and nontaxable benefits without the election itself 
resulting in inclusion in gross income by the employees. Section 125 
provides that cash (including certain taxable benefits) offered to an 
employee through a nondiscriminatory cafeteria plan is not includible 
in the employee's gross income merely because the employee has the 
opportunity to choose among cash and qualified benefits (within the 
meaning of section 125(e)) through the cafeteria plan. Section 125(a), 
(d)(1). However, if a plan offering an employee an election between 
taxable benefits (including cash) and nontaxable qualified benefits 
does not meet the section 125 requirements, the election between 
taxable and nontaxable benefits results in gross income to the 
employee, regardless of what benefit is elected and when the election 
is made. An employee who has an election among nontaxable benefits and 
taxable benefits (including cash) that is not through a cafeteria plan 
that satisfies section 125 must include in gross income the value of 
the taxable benefit with the greatest value that the employee could 
have elected to receive, even if the employee elects to receive only 
the nontaxable benefits offered. The amount of the taxable benefit is 
includible in the

[[Page 43947]]

employee's income in the year in which the employee would have actually 
received the taxable benefit if the employee had elected such benefit. 
This is the result even if the employee's election between the 
nontaxable benefits and taxable benefits is made prior to the year in 
which the employee would actually have received the taxable benefits. 
See paragraph (q) in Sec.  1.125-1 for nonqualified benefits.
    (2) Nondiscrimination rules for qualified benefits. Accident and 
health plan coverage, group-term life insurance coverage, and benefits 
under a dependent care assistance program or adoption assistance 
program do not fail to be qualified benefits under a cafeteria plan 
merely because they are includible in gross income because of 
applicable nondiscrimination requirements (for example, sections 79(d), 
105(h),129(d), 137(c)(2)). See also Sec. Sec.  1.105-11(k) and 1.125-7.
    (3) Examples. The following examples illustrate the rules of 
paragraph (b)(1) of this section.

    Example 1. Distributions from qualified pension plan used for 
health insurance premiums. (i) Employer A maintains a qualified 
section 401(a) retirement plan for employees. Employer A also 
provides accident and health insurance (as described in section 106) 
for employees and former employees, their spouses and dependents. 
The health insurance premiums are partially paid through a cafeteria 
plan. None of Employer A's employees are public safety officers. 
Employer A's health plan allows former employees to elect to have 
distributions from the qualified retirement plan applied to pay for 
the health insurance premiums through the cafeteria plan.
    (ii) Amounts distributed from the qualified retirement plan 
which the former employees elect to have applied to pay health 
insurance premiums through the cafeteria plan are includible in 
their gross income. The same result occurs if distributions from the 
qualified retirement plan are applied directly to reimburse section 
213(d) medical care expenses incurred by a former employee or his or 
her spouse or dependents. These distributions are includible in 
their income, and are not cash for purposes of section 125. The plan 
is not a cafeteria plan with respect to former employees.
    Example 2. Severance pay used to pay COBRA premiums. Employer B 
maintains a cafeteria plan, which offers employees an election 
between cash and employer-provided accident and health insurance 
(excludible from employees' gross income under section 106). 
Employer B pays terminating employees severance pay. The cafeteria 
plan also allows a terminating employee to elect between receiving 
severance pay and using the severance pay to pay the COBRA premiums 
for the accident and health insurance. These provisions in the 
cafeteria plan are consistent with the requirements in section 125.

    (4) Election by participants--(i) In general. A cafeteria plan must 
offer participants the opportunity to elect between at least one 
permitted taxable benefit and at least one qualified benefit. For 
example, if employees are given the opportunity to elect only among two 
or more nontaxable benefits, the plan is not a cafeteria plan. 
Similarly, a plan that only offers the election among salary, permitted 
taxable benefits, paid time off or other taxable benefits is not a 
cafeteria plan. See section 125(a), (d). See Sec.  1.125-2 for rules on 
elections.
    (ii) Premium-only-plan. A cafeteria plan may be a premium-only-
plan.
    (iii) Examples. The following examples illustrate the rules of 
paragraph (b)(4)(i) of this section.

    Example 1. No election. Employer C covers all its employees 
under its accident and health plan (excludible from employees' gross 
income under section 106). Coverage is mandatory (that is, employees 
have no election between cash and the Employer C's accident and 
health plan). This plan is not a cafeteria plan, because the plan 
offers employees no election between taxable and nontaxable 
benefits. The accident and health coverage is excludible from 
employees' gross income.
    Example 2. Election between cash and at least one qualified 
benefit. Employer D offers its employees a plan with an election 
between cash and an employer-provided accident and health plan 
(excludible from employees' gross income under section 106). If the 
plan also satisfies all the other requirements of section 125, the 
plan is a cafeteria plan because it offers an election between at 
least one taxable benefit and at least one nontaxable qualified 
benefit.
    Example 3. Election between employer flex-credits and qualified 
benefits. Employer E offers its employees an election between an 
employer flex-credit (as defined in paragraph (b) in Sec.  1.125-5) 
and qualified benefits. If an employee does not elect to apply the 
entire employer flex-credit to qualified benefits, the employee will 
receive no cash or other taxable benefit for the unused employer 
flex-credit. The plan is not a cafeteria plan because it does not 
offer an election between at least one taxable benefit and at least 
one nontaxable qualified benefit.
    Example 4. No election between cash and qualified benefits for 
certain employees. (i) Employer F maintains a calendar year plan 
offering employer-provided accident and health insurance coverage 
which includes employee-only and family coverage options.

    (ii) The plan provides for an automatic enrollment process when 
a new employee is hired, or during the annual election period under 
the plan: only employees who certify that they have other health 
coverage are permitted to elect to receive cash. Employees who 
cannot certify are covered by the accident and health insurance on a 
mandatory basis. Employer F does not otherwise request or collect 
information from employees regarding other health coverage as part 
of the enrollment process. If the employee has a spouse or child, 
the employee can elect between cash and family coverage.
    (iii) When an employee is hired, the employee receives a notice 
explaining the plan's automatic enrollment process. The notice 
includes the salary reduction amounts for employee-only coverage and 
family coverage, procedures for certifying whether the employee has 
other health coverage, elections for family coverage, information on 
the time by which a certification or election must be made, and the 
period for which a certification or election will be effective. The 
notice is also given to each current employee before the beginning 
of each plan year, (except that the notice for a current employee 
includes a description of the employee's existing coverage, if any).
    (iv) For a new employee, an election to receive cash or to have 
family coverage is effective if made when the employee is hired. For 
a current employee, an election is effective if made prior to the 
start of each calendar year or under any other circumstances 
permitted under Sec.  1.125-4. An election for any prior year 
carries over to the next succeeding plan year unless changed. 
Certification that the employee has other health coverage must be 
made annually.
    (v) Contributions used to purchase employer-provided accident 
and health coverage under section 125 are not includible in an 
employee's gross income if the employee can elect cash. Section 125 
does not apply to the employee-only coverage of an employee who 
cannot certify that he or she has other health coverage and, 
therefore, does not have the ability to elect cash in lieu of health 
coverage.

    (5) No deferred compensation. Except as provided in paragraph (o) 
of this section, in order for a plan to be a cafeteria plan, the 
qualified benefits and the permitted taxable benefits offered through 
the cafeteria plan must not defer compensation. For example, a 
cafeteria plan may not provide for retirement health benefits for 
current employees beyond the current plan year or group-term life 
insurance with a permanent benefit, as defined under Sec.  1.79-0.
    (c) Written plan requirements--(1) General rule. A cafeteria plan 
must contain in writing the information described in this paragraph 
(c), and depending on the qualified benefits offered in the plan, may 
also be required to contain additional information described in 
paragraphs (c)(2) and (c)(3) of this section. The cafeteria plan must 
be adopted and effective on or before the first day of the cafeteria 
plan year to which it relates. The terms of the plan must apply 
uniformly to all participants. The cafeteria plan document may be 
comprised of multiple documents. The written cafeteria plan must 
contain all of the following information--

[[Page 43948]]

    (i) A specific description of each of the benefits available 
through the plan, including the periods during which the benefits are 
provided (the periods of coverage);
    (ii) The plan's rules governing participation, and specifically 
requiring that all participants in the plan be employees;
    (iii) The procedures governing employees' elections under the plan, 
including the period when elections may be made, the periods with 
respect to which elections are effective, and providing that elections 
are irrevocable, except to the extent that the optional change in 
status rules in Sec.  1.125-4 are included in the cafeteria plan;
    (iv) The manner in which employer contributions may be made under 
the plan, (for example, through an employee's salary reduction election 
or by nonelective employer contributions (that is, flex-credits, as 
defined in paragraph (b) in Sec.  1.125-5) or both);
    (v) The maximum amount of employer contributions available to any 
employee through the plan, by stating:
    (A) The maximum amount of elective contributions (i.e., salary 
reduction) available to any employee through the plan, expressed as a 
maximum dollar amount or a maximum percentage of compensation or the 
method for determining the maximum dollar amount; and
    (B) For contributions to section 401(k) plans, the maximum amount 
of elective contributions available to any employee through the plan, 
expressed as a maximum dollar amount or maximum percentage of 
compensation that may be contributed as elective contributions through 
the plan by employees.
    (vi) The plan year of the cafeteria plan;
    (vii) If the plan offers paid time off, the required ordering rule 
for use of nonelective and elective paid time off in paragraph (o)(4) 
of this section;
    (viii) If the plan includes flexible spending arrangements (as 
defined in Sec.  1.125-5(a)), the plan's provisions complying with any 
additional requirements for those FSAs (for example, the uniform 
coverage rule and the use-or-lose rules in paragraphs (d) and (c) in 
Sec.  1.125-5);
    (ix) If the plan includes a grace period, the plan's provisions 
complying with paragraph (e) of this section; and
    (x) If the plan includes distributions from a health FSA to 
employees' HSAs, the plan's provisions complying with paragraph (n) in 
Sec.  1.125-5.
    (2) Additional requirements under sections 105(h), 129, and 137. A 
written plan is required for self-insured medical reimbursement plans 
(Sec.  1.105-11(b)(1)(i)), dependent care assistance programs (section 
129(d)(1)), and adoption assistance (section 137(c)). Any of these 
plans or programs offered through a cafeteria plan that satisfies the 
written plan requirement in this paragraph (c) for the benefits under 
these plans and programs also satisfies the written plan requirements 
in Sec.  1.105-11(b)(1)(i), section 129(d)(1), and section 137(c) 
(whichever is applicable). Alternatively, a self-insured medical 
reimbursement plan, a dependent care assistance program, or an adoption 
assistance program is permitted to satisfy the requirements in Sec.  
1.105-11(b)(1)(i), section 129(d)(1), or section 137(c) (whichever is 
applicable) through a separate written plan, and not as part of the 
written cafeteria plan.
    (3) Additional requirements under section 401(k). See Sec.  
1.401(k)-1(e)(7) for additional requirements that must be satisfied in 
the written plan if the plan offers deferrals into a section 401(k) 
plan.
    (4) Cross-reference allowed. In describing the benefits available 
through the cafeteria plan, the written cafeteria plan need not be 
self-contained. For example, the written cafeteria plan may incorporate 
by reference benefits offered through other separate written plans, 
such as a section 401(k) plan, or coverage under a dependent care 
assistance program (section 129), without describing in full the 
benefits established through these other plans. But, for example, if 
the cafeteria plan offers different maximum levels of coverage for 
dependent care assistance programs, the descriptions in the separate 
written plan must specify the available maximums.
    (5) Amendments to cafeteria plan. Any amendment to the cafeteria 
plan must be in writing. A cafeteria plan is permitted to be amended at 
any time during a plan year. However, the amendment is only permitted 
to be effective for periods after the later of the adoption date or 
effective date of the amendment. For an amendment adding a new benefit, 
the cafeteria plan must pay or reimburse only those expenses for new 
benefits incurred after the later of the amendment's adoption date or 
effective date.
    (6) Failure to satisfy written plan requirements. If there is no 
written cafeteria plan, or if the written plan fails to satisfy any of 
the requirements in this paragraph (c) (including cross-referenced 
requirements), the plan is not a cafeteria plan and an employee's 
election between taxable and nontaxable benefits results in gross 
income to the employee.
    (7) Operational failure--(i) In general. If the cafeteria plan 
fails to operate according to its written plan or otherwise fails to 
operate in compliance with section 125 and the regulations, the plan is 
not a cafeteria plan and employees' elections between taxable and 
nontaxable benefits result in gross income to the employees.
    (ii) Failure to operate according to written cafeteria plan or 
section 125. Examples of failures resulting in section 125 not applying 
to a plan include the following--
    (A) Paying or reimbursing expenses for qualified benefits incurred 
before the later of the adoption date or effective date of the 
cafeteria plan, before the beginning of a period of coverage or before 
the later of the date of adoption or effective date of a plan amendment 
adding a new benefit;
    (B) Offering benefits other than permitted taxable benefits and 
qualified benefits;
    (C) Operating to defer compensation (except as permitted in 
paragraph (o) of this section);
    (D) Failing to comply with the uniform coverage rule in paragraph 
(d) in Sec.  1.125-5;
    (E) Failing to comply with the use-or-lose rule in paragraph (c) in 
Sec.  1.125-5;
    (F) Allowing employees to revoke elections or make new elections, 
except as provided in Sec.  1.125-4 and paragraph (a) in Sec.  1.125-2;
    (G) Failing to comply with the substantiation requirements of Sec.  
1.125-6;
    (H) Paying or reimbursing expenses in an FSA other than expenses 
expressly permitted in paragraph (h) in Sec.  1.125-5;
    (I) Allocating experience gains other than as expressly permitted 
in paragraph (o) in Sec.  1.125-5;
    (J) Failing to comply with the grace period rules in paragraph (e) 
of this section; or
    (K) Failing to comply with the qualified HSA distribution rules in 
paragraph (n) in Sec.  1.125-5.
    (d) Plan year requirements--(1) Twelve consecutive months. The plan 
year must be specified in the cafeteria plan. The plan year of a 
cafeteria plan must be twelve consecutive months, unless a short plan 
year is allowed under this paragraph (d). A plan year is permitted to 
begin on any day of any calendar month and must end on the preceding 
day in the immediately following year (for example, a plan year that 
begins on October 15, 2007, must end on October 14, 2008). A calendar 
year plan year is a period of twelve consecutive months beginning on 
January 1 and ending on December 31 of the same calendar year. A plan 
year

[[Page 43949]]

specified in the cafeteria plan is effective for the first plan year of 
a cafeteria plan and for all subsequent plan years, unless changed as 
provided in paragraph (d)(2) of this section.
    (2) Changing plan year. The plan year is permitted to be changed 
only for a valid business purpose. A change in the plan year is not 
permitted if a principal purpose of the change in plan year is to 
circumvent the rules of section 125 or these regulations. If a change 
in plan year does not satisfy this subparagraph, the attempt to change 
the plan year is ineffective and the plan year of the cafeteria plan 
remains the same.
    (3) Short plan year. A short plan year of less than twelve 
consecutive months is permitted for a valid business purpose.
    (4) Examples. The following examples illustrate the rules in 
paragraph (d) of this section:

    Example 1. Employer with calendar year. Employer G, with a 
calendar taxable year, first establishes a cafeteria plan effective 
July 1, 2009. The cafeteria plan specifies a calendar plan year. The 
first cafeteria plan year is the period beginning on July 1, 2009, 
and ending on December 31, 2009. Employer G has a business purpose 
for a short first cafeteria plan year.
    Example 2. Employer changes insurance carrier. Employer H 
establishes a cafeteria plan effective January 1, 2009, with a 
calendar year plan year. The cafeteria plan offers an accident and 
health plan through Insurer X. In March 2010, Employer H contracts 
to provide accident and health insurance through another insurance 
company, Y. Y's accident and health insurance is offered on a July 
1-June 30 benefit year. Effective July 1, 2010, Employer H amends 
the plan to change to a July 1-June 30 plan year. Employer H has a 
business purpose for changing the cafeteria plan year and for the 
short plan year ending June 30, 2010.
    (5) Significance of plan year. The plan year generally is the 
coverage period for benefits provided through the cafeteria plan to 
which annual elections for these benefits apply. Benefits elected 
pursuant to the employee's election for a plan year generally may not 
be carried forward to subsequent plan years. However, see the grace 
period rule in paragraph (e) of this section.
    (e) Grace period--(1) In general. A cafeteria plan may, at the 
employer's option, include a grace period of up to the fifteenth day of 
the third month immediately following the end of each plan year. If a 
cafeteria plan provides for a grace period, an employee who has unused 
benefits or contributions relating to a qualified benefit (for example, 
health flexible spending arrangement (health FSA) or dependent care 
assistance) from the immediately preceding plan year, and who incurs 
expenses for that same qualified benefit during the grace period, may 
be paid or reimbursed for those expenses from the unused benefits or 
contributions as if the expenses had been incurred in the immediately 
preceding plan year. A grace period is available for all qualified 
benefits described in paragraph (a)(3) of this section, except that the 
grace period does not apply to paid time off and elective contributions 
under a section 401(k) plan. The effect of the grace period is that the 
employee may have as long as 14 months and 15 days (that is, the 12 
months in the current cafeteria plan year plus the grace period) to use 
the benefits or contributions for a plan year before those amounts are 
forfeited under the use-or-lose rule in paragraph (c) in Sec.  1.125-5. 
If the grace period is added to a cafeteria plan through an amendment, 
all requirements in paragraph (c) of this section must be satisfied.
    (2) Grace period optional features. A grace period provision may 
contain any or all of the following--
    (i) The grace period may apply to some qualified benefits described 
in paragraph (a)(3) of this section, but not to others;
    (ii) The grace period provision may limit the amount of unused 
benefits or contributions available during the grace period. The limit 
must be uniform and apply to all participants. However, the limit must 
not be based on a percentage of the amount of the unused benefits or 
contributions remaining at the end of the immediately prior plan year;
    (iii) The last day of the grace period may be sooner than the 
fifteenth day of the third month immediately following the end of the 
plan year (that is, the grace period may be shorter than two and one 
half months);
    (iv) The grace period provision is permitted to treat expenses for 
qualified benefits incurred during the grace period either as expenses 
incurred during the immediately preceding plan year or as expenses 
incurred during the current plan year (for example, the plan may first 
apply the unused contributions or benefits from the immediately 
preceding year to pay or reimburse grace period expenses and then, when 
the unused contributions and benefits from the prior year are 
exhausted, the grace period expenses may be paid from current year 
contributions and benefits.); and
    (v) The grace period provision may permit the employer to defer the 
allocation of expenses described in paragraph (e)(2)(iv) of this 
section until after the end of the grace period.
    (3) Grace period requirements. A grace period must satisfy the 
requirements in paragraph (c) of this section and all of the following 
requirements:
    (i) The grace period provisions in the cafeteria plan (including 
optional provisions in paragraph (e)(2) of this section) must apply 
uniformly to all participants in the cafeteria plan, determined as of 
the last day of the plan year. Participants in the cafeteria plan 
through COBRA and participants who were participants as of the last day 
of the plan year but terminate during the grace period are participants 
for purposes of the grace period. See Sec.  54.4980B-2, Q & A-8 of this 
chapter;
    (ii) The grace period provision in the cafeteria plan must state 
that unused benefits or contributions relating to a particular 
qualified benefit may only be used to pay or reimburse expenses 
incurred with respect to the same qualified benefit. For example, 
unused amounts elected to pay or reimburse medical expenses in a health 
FSA may not be used to pay or reimburse dependent care expenses 
incurred during the grace period; and
    (iii) The grace period provision in the cafeteria plan must state 
that to the extent any unused benefits or contributions from the 
immediately preceding plan year exceed the expenses for the qualified 
benefit incurred during the grace period, those remaining unused 
benefits or contributions may not be carried forward to any subsequent 
period (including any subsequent plan year), cannot be cashed-out and 
must be forfeited under the use-or-lose rule. See paragraph (c) in 
Sec.  1.125-5
    (4) Examples. The following examples illustrate the rules in this 
paragraph (e).
    Example 1. Expenses incurred during grace period and immediately 
following plan year. (i) Employer I's calendar year cafeteria plan 
includes a grace period allowing all participants to apply unused 
benefits or contributions remaining at the end of the plan year to 
qualified benefits incurred during the grace period immediately 
following that plan year. The grace period for the plan year ending 
December 31, 2009, ends on March 15, 2010.
    (ii) Employee X timely elected salary reduction of $1,000 for a 
health FSA for the plan year ending December 31, 2009. As of 
December 31, 2009, X has $200 remaining unused in his health FSA. X 
timely elected salary reduction for a health FSA of $1,500 for the 
plan year ending December 31, 2010.
    (iii) During the grace period from January 1 through March 15, 
2010, X incurs $300 of unreimbursed medical expenses (as defined in 
section 213(d)). The unused $200 from the plan year ending December 
31, 2009, is applied to pay or reimburse $200 of X's $300 of medical 
expenses incurred during the grace period. Therefore, as of March 
16, 2010, X has no unused benefits or contributions

[[Page 43950]]

remaining for the plan year ending December 31, 2009.
    (iv) The remaining $100 of medical expenses incurred between 
January 1 and March 15, 2010, is paid or reimbursed from X's health 
FSA for the plan year ending December 31, 2010. As of March 16, 
2010, X has $1,400 remaining in the health FSA for the plan year 
ending December 31, 2010.
    Example 2. Unused benefits exceed expenses incurred during grace 
period. Same facts as Example 1, except that X incurs $150 of 
section 213(d) medical expenses during the grace period (January 1 
through March 15, 2010). As of March 16, 2010, X has $50 of unused 
benefits or contributions remaining for the plan year ending 
December 31, 2009. The unused $50 cannot be cashed-out, converted to 
any other taxable or nontaxable benefit, or used in any other plan 
year (including the plan year ending December 31, 2009). The unused 
$50 is subject to the use-or-lose rule in paragraph (c) in Sec.  
1.125-5 and is forfeited. As of March 16, 2010, X has the entire 
$1,500 elected in the health FSA for the plan year ending December 
31, 2010.
    Example 3. Terminated participants. (i) Employer J's cafeteria 
plan includes a grace period allowing all participants to apply 
unused benefits or contributions remaining at the end of the plan 
year to qualified benefits incurred during the grace period 
immediately following that plan year. For the plan year ending on 
December 31, 2009, the grace period ends March 15, 2010.
    (ii) Employees A, B, C, and D each timely elected $1,200 salary 
reduction for a health FSA for the plan year ending December 31, 
2009. Employees A and B terminated employment on September 15, 2009. 
Each has $500 of unused benefits or contributions in the health FSA.
    (iii) Employee A elected COBRA for the health FSA. Employee A is 
a participant in the cafeteria plan as of December 31, 2009, the 
last day of the 2009 plan year. Employee A has $500 of unused 
benefits or contributions available during the grace period for the 
2009 plan year (ending March 15, 2010).
    (iv) Employee B did not elect COBRA for the health FSA. Employee 
B is not a participant in the cafeteria plan as of December 31, 
2009. The grace period does not apply to Employee B.
    (v) Employee C has $500 of unused benefits in his health FSA as 
of December 31, 2009, and terminated employment on January 15, 2010. 
Employee C is a participant in the cafeteria plan as of December 31, 
2009 and has $500 of unused benefits or contributions available 
during the grace period ending March 15, 2010, even though he 
terminated employment on January 15, 2010.
    (vi) Employee D continues to work for Employer H throughout 2009 
and 2010, also has $500 of unused benefits or contributions in his 
health FSA as of December 31, 2009, but made no health FSA election 
for 2010. Employee D is a participant in the cafeteria plan as of 
December 31, 2009 and has $500 of unused benefits or contributions 
available during the grace period ending March 15, 2010, even though 
he is not a participant in a health FSA for the 2010 plan year.

    (f) Run-out period. A cafeteria plan is permitted to contain a run-
out period as designated by the employer. A run-out period is a period 
after the end of the plan year (or grace period) during which a 
participant can submit a claim for reimbursement for a qualified 
benefit incurred during the plan year (or grace period). Thus, a plan 
is also permitted to provide a deadline on or after the end of the plan 
year (or grace period) for submitting a claim for reimbursement for the 
plan year. Any run-out period must be provided on a uniform and 
consistent basis with respect to all participants.
    (g) Employee for purposes of section 125--(1) Current employees, 
former employees. The term employee includes any current or former 
employee (including any laid-off employee or retired employee) of the 
employer. See paragraph (g)(3) of this section concerning limits on 
participation by former employees. Specifically, the term employee 
includes the following--
    (i) Common law employee;
    (ii) Leased employee described in section 414(n);
    (iii) Full-time life insurance salesman (as defined in section 
7701(a)(20)); and
    (iv) A current employee or former employee described in paragraphs 
(g)(1)(i) through (iii) of this section.
    (2) Self-employed individual not an employee--(i) In general. The 
term employee does not include a self-employed individual or a 2-
percent shareholder of an S corporation, as defined in paragraph 
(g)(2)(ii) of this subsection. For example, a sole proprietor, a 
partner in a partnership, or a director solely serving on a 
corporation's board of directors (and not otherwise providing services 
to the corporation as an employee) is not an employee for purposes of 
section 125, and thus is not permitted to participate in a cafeteria 
plan. However, a sole proprietor may sponsor a cafeteria plan covering 
the sole proprietor's employees (but not the sole proprietor). 
Similarly, a partnership or S corporation may sponsor a cafeteria plan 
covering employees (but not a partner or 2-percent shareholder of an S 
corporation).
    (ii) Two percent shareholder of an S corporation. A 2-percent 
shareholder of an S corporation has the meaning set forth in section 
1372(b).
    (iii) Certain dual status individuals. If an individual is an 
employee of an employer and also provides services to that employer as 
an independent contractor or director (for example, an individual is 
both a director and an employee of a C corp), the individual is 
eligible to participate in that employer's cafeteria plan solely in his 
or her capacity as an employee. This rule does not apply to partners or 
to 2-percent shareholders of an S corporation.
    (iv) Examples. The following examples illustrate the rules in 
paragraphs (g)(2)(ii) and (g)(2)(iii) of this section:

    Example 1. Two-percent shareholders of an S corporation. (i) 
Employer K, an S corporation, maintains a cafeteria plan for its 
employees (other than 2-percent shareholders of an S corporation). 
Employer K's taxable year and the plan year are the calendar year. 
On January 1, 2009, individual Z owns 5 percent of the outstanding 
stock in Employer K. Y, who owns no stock in Employer K, is married 
to Z. Y and Z are employees of Employer K. Z is a 2-percent 
shareholder in Employer K (as defined in section 1372(b)). Y is also 
a 2-percent shareholder in Employer K by operation of the 
attribution rules in section 318(a)(1)(A)(i).
    (ii) On July 15, 2009, Z sells all his stock in Employer K to an 
unrelated third party, and ceases to be a 2-percent shareholder. Y 
and Z continue to work as employees of Employer K during the entire 
2009 calendar year. Y and Z are ineligible to participate in 
Employer K's cafeteria plan for the 2009 plan year.
    Example 2. Director and employee. T is an employee and also a 
director of Employer L, a C corp that sponsors a cafeteria plan. The 
cafeteria plan allows only employees of Employer L to participate in 
the cafeteria plan. T's annual compensation as an employee is 
$50,000; T is also paid $3,000 annually in director's fees. T makes 
a timely election to salary reduce $5,000 from his employee 
compensation for dependent care benefits. T makes no election with 
respect to his compensation as a director. T may participate in the 
cafeteria plan in his capacity as an employee of Employer L.

    (3) Limits on participation by former employees. Although former 
employees are treated as employees, a cafeteria plan may not be 
established or maintained predominantly for the benefit of former 
employees of the employer. Such a plan is not a cafeteria plan.
    (4) No participation by the spouse or dependent of an employee--(i) 
Benefits allowed to participant's spouse or dependents but not 
participation. The spouse or dependents of employees may not be 
participants in a cafeteria plan unless they are also employees. 
However, a cafeteria plan may provide benefits to spouses and 
dependents of participants. For example, although an employee's spouse 
may benefit from the employee's election of accident and health 
insurance coverage or of coverage through a dependent care assistance 
program, the spouse may not participate in a cafeteria plan (that is, 
the spouse may not be given the opportunity to elect or purchase 
benefits offered by the plan).

[[Page 43951]]

    (ii) Certain elections after employee's death. An employee's spouse 
is not a participant in a cafeteria plan merely because the spouse has 
the right, upon the death of the employee, to elect among various 
settlement options or to elect among permissible distribution options 
with respect to the deceased employee's benefits through a section 
401(k) plan, Health Savings Account, or certain group-term life 
insurance offered through the cafeteria plan. See Sec.  54.4980B-2, Q & 
A 8 and Sec.  54.4980B-4, Q & A-1 of this chapter on COBRA rights of a 
participant's spouse or dependents.
    (5) Employees of certain controlled groups. All employees who are 
treated as employed by a single employer under section 414(b), (c), 
(m), or (o) are treated as employed by a single employer for purposes 
of section 125. Section 125(g)(4); section 414(t).
    (h) After-tax employee contributions--(1) Certain after-tax 
employee contributions treated as cash. In addition to the cash 
benefits described in paragraph (a)(2) of this section, in general, a 
benefit is treated as cash for purposes of section 125 if the benefit 
does not defer compensation (except as provided in paragraph (o) of 
this section) and an employee who receives the benefit purchases such 
benefit with after-tax employee contributions or is treated, for all 
purposes under the Code (including, for example, reporting and 
withholding purposes), as receiving, at the time that the benefit is 
received, cash compensation equal to the full value of the benefit at 
that time and then purchasing the benefit with after-tax employee 
contributions. Thus, for example, long-term disability coverage is 
treated as cash for purposes of section 125 if the cafeteria plan 
provides that an employee may purchase the coverage through the 
cafeteria plan with after-tax employee contributions or provides that 
the employee receiving such coverage is treated as having received cash 
compensation equal to the value of the coverage and then as having 
purchased the coverage with after-tax employee contributions. Also, for 
example, a cafeteria plan may offer employees the opportunity to 
purchase, with after-tax employee contributions, group-term life 
insurance on the life of an employee (providing no permanent benefits), 
an accident and health plan, or a dependent care assistance program.
    (2) Accident and health coverage purchased for someone other than 
the employee's spouse or dependents with after-tax employee 
contributions. If the requirements of section 106 are satisfied, 
employer-provided accident and health coverage for an employee and his 
or her spouse or dependents is excludible from the employee's gross 
income. The fair market value of coverage for any other individual, 
provided with respect to the employee, is includible in the employee's 
gross income. Sec.  1.106-1; Sec.  1.61-21(a)(4), and Sec.  1.61-
21(b)(1). A cafeteria plan is permitted to allow employees to elect 
accident and health coverage for an individual who is not the spouse or 
dependent of the employee as a taxable benefit.
    (3) Example. The following example illustrates the rules of this 
paragraph (h):

    Example. Accident and health plan coverage for individuals who 
are not a spouse or dependent of an employee. (i) Employee C 
participates in Employer M's cafeteria plan. Employee C timely 
elects salary reduction for employer-provided accident and health 
coverage for himself and for accident and health coverage for his 
former spouse. C's former spouse is not C's dependent. A former 
spouse is not a spouse as defined in section 152.
    (ii) The fair market value of the coverage for the former spouse 
is $1,000. Employee C has $1,000 includible in gross income for the 
accident and health coverage of his former spouse, because the 
section 106 exclusion applies only to employer-provided accident and 
health coverage for the employee or the employee's spouse or 
dependents.
    (iii) No payments or reimbursements received under the accident 
and health coverage result in gross income to Employee C or to the 
former spouse. The result is the same if the $1,000 for coverage of 
C's former spouse is paid from C's after-tax income outside the 
cafeteria plan.

    (i) Prohibited taxable benefits. Any taxable benefit not described 
in paragraph (a)(2) of this section and not treated as cash for 
purposes of section 125 in paragraph (h) of this section is not 
permitted to be included in a cafeteria plan. A plan that offers 
taxable benefits other than the taxable benefits described in paragraph 
(a)(2) and (h) of this section is not a cafeteria plan.
    (j) Coordination with other rules--(1) In general. If a benefit is 
excludible from an employee's gross income when provided separately, 
the benefit is excludible from gross income when provided through a 
cafeteria plan. Thus, a qualified benefit is excludible from gross 
income if both the rules under section 125 and the specific rules 
providing for the exclusion of the benefit from gross income are 
satisfied. For example, if the nondiscrimination rules for specific 
qualified benefits (for example, sections 79(d), 105(h), 129(d)(2), 
137(c)(2)) are not satisfied, those qualified benefits are includible 
in gross income. Thus, if $50,000 in group-term life insurance is 
offered through a cafeteria plan, the nondiscrimination rules in 
section 79(d) must be satisfied in order to exclude the coverage from 
gross income.
    (2) Section 125 nondiscrimination rules. Qualified benefits are 
includible in the gross income of highly compensated participants or 
key employees if the nondiscrimination rules of section 125 are not 
satisfied. See Sec.  1.125-7.
    (3) Taxable benefits. If a benefit that is includible in gross 
income when offered separately is offered through a cafeteria plan, the 
benefit continues to be includible in gross income.
    (k) Group-term life insurance--(1) In general. In addition to 
offering up to $50,000 in group-term life insurance coverage excludible 
under section 79(a), a cafeteria plan may offer coverage in excess of 
that amount. The cost of coverage in excess of $50,000 in group-term 
life insurance coverage provided under a policy or policies carried 
directly or indirectly by one or more employers (taking into account 
all coverage provided both through a cafeteria plan and outside a 
cafeteria plan) is includible in an employee's gross income. Group-term 
life insurance combined with permanent benefits, within the meaning of 
Sec.  1.79-0, is a prohibited benefit in a cafeteria plan.
    (2) Determining cost of insurance includible in employee's gross 
income--(i) In general. If the aggregate group-term life insurance 
coverage on the life of the employee (under policies carried directly 
or indirectly by the employer) exceeds $50,000, all or a portion of the 
insurance is provided through a cafeteria plan, and the group-term life 
insurance is provided through a plan that meets the nondiscrimination 
rules of section 79(d), the amount includible in an employee's gross 
income is determined under paragraphs (k)(2)(i)(A) through (C) of this 
section. For each employee--
    (A) The entire amount of salary reduction and employer flex-credits 
through a cafeteria plan for group-term life insurance coverage on the 
life of the employee is excludible from the employee's gross income, 
regardless of the amount of employer-provided group-term life insurance 
on the employee's life (that is, whether or not the coverage provided 
to the employee both through the cafeteria plan and outside the 
cafeteria plan exceeds $50,000);
    (B) The cost of the group-term life insurance in excess of $50,000 
of coverage is includible in the employee's gross income. The amount 
includible in the employee's income is determined

[[Page 43952]]

using the rules of Sec.  1.79-3 and Table I (Uniform Premiums for 
$1,000 of Group-Term Life Insurance Protection). See subparagraph (C) 
of this paragraph (k)(2)(i) for determining the amount paid by the 
employee for purposes of reducing the Table I amount includible in 
income under Sec.  1.79-3.
    (C) In determining the amount paid by the employee toward the 
purchase of the group-term life insurance for purposes of Sec.  1.79-3, 
only an employee's after-tax contributions are treated as an amount 
paid by the employee.
    (ii) Examples. The rules in this paragraph (k) are illustrated by 
the following examples, in which the group-term life insurance coverage 
satisfies the nondiscrimination rules in section 79(d), provides no 
permanent benefits, is for a 12-month period, is the only group-term 
life insurance coverage provided under a policy carried directly or 
indirectly by the employer, and applies Table I (Uniform Premiums for 
$1,000 of Group-Term Life Insurance Protection) effective July 1, 1999:

    Example 1. Excess group-term life insurance coverage provided 
through salary reduction in a cafeteria plan. (i) Employer N 
provides group-term life insurance coverage to its employees only 
through its cafeteria plan. Employer N's cafeteria plan allows 
employees to elect salary reduction for group-term life insurance. 
Employee B, age 42, elected salary reduction of $200 for $150,000 of 
group-term life insurance. None of the group-term life insurance is 
paid through after-tax employee contributions.
    (ii) B's $200 of salary reduction for group-term life insurance 
is excludible from B's gross income under paragraph (k)(2)(i)(A).
    (iii) B has a total of $150,000 of group-term life insurance. 
The group-term life insurance in excess of the dollar limitation of 
section 79 is $100,000 (150,000-50,000).
    (iv) The Table I cost is $120 for $100,000 of group-term life 
insurance for an individual between ages 40 to 44. The Table I cost 
of $120 is reduced by zero (because B paid no portion of the group-
term life insurance with after-tax employee contributions), under 
paragraphs (k)(2)(i)(A)-(B) of this section.
    (v) The amount includible in B's gross income for the $100,000 
of excess group-term life insurance is $120.
    Example 2. Excess group-term life insurance coverage provided 
through salary reduction in a cafeteria plan where employee 
purchases a portion of group-term life insurance coverage with 
after-tax contributions. (i) Same facts as Example 1, except that B 
elected salary reduction of $100 and makes an after-tax contribution 
of $100 toward the purchase of group-term life insurance coverage.
    (ii) B's $100 of salary reduction for group-term life insurance 
is excludible from B's gross income, under paragraph (k)(2)(i)(A) of 
this section.
    (iii) B has a total of $150,000 of group-term life insurance. 
The group-term life insurance in excess of the dollar limitation of 
section 79 is $100,000 (150,000-50,000).
    (iv) The Table I cost is $120 for $100,000 of group-term life 
insurance for an individual between ages 40 to 44, under 
(k)(2)(i)(B). The Table I cost of $120 is reduced by $100 (because B 
paid $100 for the group-term life insurance with after-tax employee 
contributions), under paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of 
this section.
    (v) The amount includible in B's gross income for the $100,000 
of excess group-term life insurance coverage is $20.
    Example 3. Excess group-term life insurance coverage provided 
through salary reduction in a cafeteria plan and outside a cafeteria 
plan. (i) Same facts as Example 1 except that Employer N also 
provides (at no cost to employees) group-term life insurance 
coverage equal to each employee's annual salary. Employee B's annual 
salary is $150,000. B has $150,000 of group-term life insurance 
directly from Employer N, and also $150,000 coverage through 
Employer N's cafeteria plan.
    (ii) B's $200 of salary reduction for group-term life insurance 
is excludible from B's gross income, under paragraph (k)(2)(i)(A) of 
this section.
    (iii) B has a total of $300,000 of group-term life insurance. 
The group-term life insurance in excess of the dollar limitation of 
section 79 is $250,000 (300,000-50,000).
    (iv) The Table I cost is $300 for $250,000 of group-term life 
insurance for an individual between ages 40 to 44. The Table I cost 
of $300 is reduced by zero (because B paid no portion of the group-
term life insurance with after-tax employee contributions), under 
paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section.
    (v) The amount includible in B's gross income for the $250,000 
of excess group-term life insurance is $300.
    Example 4. Excess group-term life insurance coverage provided 
through salary reduction in a cafeteria plan and outside a cafeteria 
plan. (i) Same facts as Example 3 except that Employee C's annual 
salary is $30,000. C has $30,000 of group-term life insurance 
coverage provided directly from Employer N, and elects an additional 
$30,000 of coverage for $40 through Employer N's cafeteria plan. C 
is 42 years old.
    (ii) C's $40 of salary reduction for group-term life insurance 
is excludible from C's gross income, under paragraph (k)(2)(i)(A) of 
this section.
    (iii) C has a total of $60,000 of group-term life insurance. The 
group-term life insurance in excess of the dollar limitation of 
section 79 is $10,000 (60,000-50,000).
    (iv) The Table I cost is $12 for $10,000 of group-term life 
insurance for an individual between ages 40 to 44. The Table I cost 
of $12 is reduced by zero (because C paid no portion of the group-
term life insurance with after-tax employee contributions), under 
paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section.
    (v) The amount includible in C's gross income for the $10,000 of 
excess group-term life insurance coverage is $12.

    (l) COBRA premiums--(1) Paying COBRA premiums through a cafeteria 
plan. Under Sec.  1.125-4(c)(3)(iv), COBRA premiums for an employer-
provided group health plan are qualified benefits if:
    (i) The premiums are excludible from an employee's income under 
section 106; or
    (ii) The premiums are for the accident and health plan of the 
employer sponsoring the cafeteria plan, even if the fair market value 
of the premiums is includible in an employee's gross income. See also 
paragraph (e)(2) in Sec.  1.125-5 and Sec.  54.4980B-2, Q & A-8 of this 
chapter for COBRA rules for health FSAs.
    (2) Example. The following example illustrates the rules of this 
paragraph (l):

    Example. COBRA premiums. (i) Employer O maintains a cafeteria 
plan for full-time employees, offering an election between cash and 
employer-provided accident and health insurance and other qualified 
benefits. Employees A, B, and C participate in the cafeteria plan. 
On July 1, 2009, Employee A has a qualifying event (as defined in 
Sec.  54.4980B-4 of this chapter).
    (ii) Employee A was a full-time employee and became a part-time 
employee and for that reason, is no longer covered by Employer O's 
accident and health plan. Under Sec.  1.125-4(f)(3)(ii), Employee A 
changes her election to salary reduce to pay her COBRA premiums.
    (iii) Employee B previously worked for another employer, quit 
and elected COBRA. Employee B begins work for Employer O on July 1, 
2009, and becomes eligible to participate in Employer O's cafeteria 
plan on July 1, 2009, but will not be eligible to participate in 
Employer O's accident and health plan until October 1, 2009. 
Employee B elects to salary reduce to pay COBRA premiums for 
coverage under the accident and health plan sponsored by B's former 
employer.
    (iv) Employee C and C's spouse are covered by Employer O's 
accident and health plan until July 1, 2009, when C's divorce from 
her spouse became final. C continues to be covered by the accident 
and health plan. On July 1, 2009, C requests to pay COBRA premiums 
for her former spouse (who is not C's dependent (as defined in 
section 152)) with after-tax employee contributions.
    (v) Salary reduction elections for COBRA premiums for Employees 
A and B are qualified benefits for purposes of section 125 and are 
excludible from the gross income of Employees A and B. Employer O 
allows A and B to salary reduce for these COBRA premiums.
    (vi) Employer O allows C to pay for COBRA premiums for C's 
former spouse, with after-tax employee contributions because 
although accident and health coverage for C's former spouse is 
permitted in a cafeteria plan, the premiums are includible in C's 
gross income.
    (vii) The operation of Employer O's cafeteria plan satisfies the 
requirements of this paragraph (l).

    (m) Payment or reimbursement of employees' individual accident and

[[Page 43953]]

health insurance premiums--(1) In general. The payment or reimbursement 
of employees' substantiated individual health insurance premiums is 
excludible from employees' gross income under section 106 and is a 
qualified benefit for purposes of section 125.
    (2) Example. The following example illustrates the rule of this 
paragraph (m):

    Example. Payment or reimbursement of premiums. (i) Employer P's 
cafeteria plan offers the following benefits for employees who are 
covered by an individual health insurance policy. The employee 
substantiates the expenses for the premiums for the policy (as 
required in paragraph (b)(2) in Sec.  1.125-6) before any payments 
or reimbursements to the employee for premiums are made. The 
payments or reimbursements are made in the following ways:
    (ii) The cafeteria plan reimburses each employee directly for 
the amount of the employee's substantiated health insurance premium;
    (iii) The cafeteria plan issues the employee a check payable to 
the health insurance company for the amount of the employee's health 
insurance premium, which the employee is obligated to tender to the 
insurance company;
    (iv) The cafeteria plan issues a check in the same manner as 
(iii), except that the check is payable jointly to the employee and 
the insurance company; or
    (v) Under these circumstances, the individual health insurance 
policies are accident and health plans as defined in Sec.  1.106-1. 
This benefit is a qualified benefit under section 125.

    (n) Section 105 rules for accident and health plan offered through 
a cafeteria plan--(1) General rule. In order for an accident and health 
plan to be a qualified benefit that is excludible from gross income if 
elected through a cafeteria plan, the cafeteria plan must satisfy 
section 125 and the accident and health plan must satisfy section 
105(b) and (h).
    (2) Section 105(b) requirements in general. Section 105(b) provides 
an exclusion from gross income for amounts paid to an employee from an 
employer-funded accident and health plan specifically to reimburse the 
employee for certain expenses for medical care (as defined in section 
213(d)) incurred by the employee or the employee's spouse or dependents 
during the period for which the benefit is provided to the employee 
(that is, when the employee is covered by the accident and health 
plan).
    (o) Prohibition against deferred compensation--(1) In general. Any 
plan that offers a benefit that defers compensation (except as provided 
in this paragraph (o)) is not a cafeteria plan. See section 
125(d)(2)(A). A plan that permits employees to carry over unused 
elective contributions, after-tax contributions, or plan benefits from 
one plan year to another (except as provided in paragraphs (e), (o)(3) 
and (4) and (p) of this section) defers compensation. This is the case 
regardless of how the contributions or benefits are used by the 
employee in the subsequent plan year (for example, whether they are 
automatically or electively converted into another taxable or 
nontaxable benefit in the subsequent plan year or used to provide 
additional benefits of the same type). Similarly, a cafeteria plan also 
defers compensation if the plan permits employees to use contributions 
for one plan year to purchase a benefit that will be provided in a 
subsequent plan year (for example, life, health or disability if these 
benefits have a savings or investment feature, such as whole life 
insurance). See also Q & A-5 in Sec.  1.125-3, prohibiting deferring 
compensation from one cafeteria plan year to a subsequent cafeteria 
plan year. See paragraph (e) of this section for grace period rules. A 
plan does not defer compensation merely because it allocates experience 
gains (or forfeitures) among participants in compliance with paragraph 
(o) in Sec.  1.125-5.
    (2) Effect if a plan includes a benefit that defers the receipt of 
compensation or a plan operates to defer compensation. If a plan 
violates paragraph (o)(1) of this section, the availability of an 
election between taxable and nontaxable benefits under such a plan 
results in gross income to the employees.
    (3) Cash or deferred arrangements that may be offered in a 
cafeteria plan. (i) In general. A cafeteria plan may offer the benefits 
set forth in this paragraph (o)(3), even though these benefits defer 
compensation.
    (ii) Elective contributions to a section 401(k) plan. A cafeteria 
plan may permit a covered employee to elect to have the employer, on 
behalf of the employee, pay amounts as contributions to a trust that is 
part of a profit-sharing or stock bonus plan or rural cooperative plan 
(within the meaning of section 401(k)(7)), which includes a qualified 
cash or deferred arrangement (as defined in section 401(k)(2)). In 
addition, after-tax employee contributions under a qualified plan 
subject to section 401(m) are permitted through a cafeteria plan. The 
right to make such contributions does not cause a plan to fail to be a 
cafeteria plan merely because, under the qualified plan, employer 
matching contributions (as defined in section 401(m)(4)(A)) are made 
with respect to elective or after-tax employee contributions.
    (iii) Additional permitted deferred compensation arrangements. A 
plan maintained by an educational organization described in section 
170(b)(1)(A)(ii) to the extent of amounts which a covered employee may 
elect to have the employer pay as contributions for post-retirement 
group life insurance is permitted through a cafeteria plan, if--
    (A) All contributions for such insurance must be made before 
retirement; and
    (B) Such life insurance does not have a cash surrender value at any 
time.
    (iv) Contributions to HSAs. Contributions to covered employees' 
HSAs as defined in section 223 (but not contributions to Archer MSAs).
    (4) Paid time off--(i) In general. A cafeteria plan is permitted to 
include elective paid time off (that is, vacation days, sick days or 
personal days) as a permitted taxable benefit through the plan by 
permitting employees to receive more paid time off than the employer 
otherwise provides to the employees on a nonelective basis, but only if 
the inclusion of elective paid time off through the plan does not 
operate to permit the deferral of compensation. In addition, a plan 
that only offers the choice of cash or paid time off is not a cafeteria 
plan and is not subject to the rules of section 125. In order to avoid 
deferral of compensation, the cafeteria plan must preclude any employee 
from using the paid time off or receiving cash, in a subsequent plan 
year, for any portion of such paid time off remaining unused as of the 
end of the plan year. (See paragraph (o)(4)(iii) of this section for 
the deadline to cash out unused elective paid time off.) For example, a 
plan that offers employees the opportunity to purchase paid time off 
(or to receive cash or other benefits through the plan in lieu of paid 
time off) is not a cafeteria plan if employees who purchase the paid 
time off for a plan year are allowed to use any unused paid time off in 
a subsequent plan year. This is the case even though the plan does not 
permit the employee to convert, in any subsequent plan year, the unused 
paid time off into any other benefit.
    (ii) Ordering of elective and nonelective paid time off. In 
determining whether a plan providing paid time off operates to permit 
the deferral of compensation, a cafeteria plan must provide that 
employees are deemed to use paid time off in the following order:
    (A) Nonelective paid time off. Nonelective paid time off (that is, 
paid time off with respect to which the employee has no election) is 
used first;

[[Page 43954]]

    (B) Elective paid time off. Elective paid time off is used after 
all nonelective paid time off is used.
    (iii) Cashing out or forfeiture of unused elective paid time off, 
in general. The cafeteria plan must provide that all unused elective 
paid time off (determined as of the last day of the plan year) must 
either be paid in cash (within the time specified in this paragraph 
(o)(4)) or be forfeited. This provision must apply uniformly to all 
participants in the cafeteria plan.
    (A) Cash out of unused elective paid time off. A plan does not 
operate to permit the deferral of compensation merely because the plan 
provides that an employee who has not used all elective paid time off 
for a plan year receives in cash the value of such unused paid time 
off. The employee must receive the cash on or before the last day of 
the cafeteria plan's plan year to which the elective contributions used 
to purchase the unused elective paid time off relate.
    (B) Forfeiture of unused elective paid time off. If the cafeteria 
plan provides for forfeiture of unused elective paid time off, the 
forfeiture must be effective on the last day of the plan year to which 
the elective contributions relate.
    (iv) No grace period for paid time off. The grace period described 
in paragraph (e) of this section does not apply to paid time off.
    (v) Examples. The following examples illustrate the rules of this 
paragraph (o)(4):

    Example 1. Plan cashes out unused elective paid time off on or 
before the last day of the plan year. (i) Employer Q provides 
employees with two weeks of paid time off for each calendar year. 
Employer Q's human resources policy (that is, outside the cafeteria 
plan), permits employees to carry over one nonelective week of paid 
time off to the next year. Employer Q maintains a calendar year 
cafeteria plan that permits the employee to purchase, with elective 
contributions, an additional week of paid time off.
    (ii) For the 2009 plan year, Employee A (with a calendar tax 
year), timely elects to purchase one additional week of paid time 
off. During 2009, Employee A uses only two weeks of paid time off. 
Employee A is deemed to have used two weeks of nonelective paid time 
off and zero weeks of elective paid time off.
    (iii) Pursuant to the cafeteria plan, the plan pays Employee A 
the value of the unused elective paid time off week in cash on 
December 31, 2009. Employer Q includes this amount on the 2009 Form 
W-2 for Employee A. This amount is included in Employee A's gross 
income in 2009. The cafeteria plan's terms and operations do not 
violate the prohibition against deferring compensation.
    Example 2. Unused nonelective paid time off carried over to next 
plan year. (i) Same facts as Example 1, except that Employee A uses 
only one week of paid time off during the year. Pursuant to the 
cafeteria plan, Employee A is deemed to have used one nonelective 
week, and having retained one nonelective week and one elective week 
of paid time off. Employee A receives in cash the value of the 
unused elective paid time off on December 31, 2009. Employer Q 
includes this amount on the 2009 Form W-2 for Employee A. Employee A 
must report this amount as gross income in 2009.
    (ii) Pursuant to Employer Q's human resources policy, Employee A 
is permitted to carry over the one nonelective week of paid time off 
to the next year. Nonelective paid time off is not part of the 
cafeteria plan (that is, neither Employer Q nor the cafeteria plan 
permit employees to exchange nonelective paid time off for other 
benefits).
    (iii) The cafeteria plan's terms and operations do not violate 
the prohibition against deferring compensation.
    Example 3. Forfeiture of unused elective paid time off. Same 
facts as Example 2, except that pursuant to the cafeteria plan, 
Employee A forfeits the remaining one week of elective paid time 
off. The cafeteria plan's terms and operations do not violate the 
prohibition against deferring compensation.
    Example 4. Unused elective paid time off carried over to next 
plan year. Same facts as Example 1, except that Employee A uses only 
two weeks of paid time off during the 2009 plan year, and, under the 
terms of the cafeteria plan, Employee A is treated as having used 
the two nonelective weeks and as having retained the one elective 
week. The one remaining week (that is, the elective week) is carried 
over to the next plan year (or the value thereof used for any other 
purpose in the next plan year). The plan operates to permit 
deferring compensation and is not a cafeteria plan.
    Example 5. Paid time off exchanged for accident and health 
insurance premiums. Employer R provides employees with four weeks of 
paid time off for a year. Employer R's calendar year cafeteria plan 
permits employees to exchange up to one week of paid time off to pay 
the employee's share of accident and health insurance premiums. For 
the 2009 plan year, Employee B (with a calendar tax year), timely 
elects to exchange one week of paid time off (valued at $769) to pay 
accident and health insurance premiums for 2009. The $769 is 
excludible from Employee B's gross income under section 106. The 
cafeteria plan's terms and operations do not violate the prohibition 
against deferring compensation.

    (p) Benefits relating to more than one year--(1) Benefits in an 
accident and health insurance policy relating to more than one year. 
Consistent with section 125(d), an accident and health insurance policy 
may include certain benefits, as set forth in this paragraph (p)(1), 
without violating the prohibition against deferred compensation.
    (i) Permitted benefits. The following features or benefits of 
insurance policies do not defer compensation--
    (A) Credit toward the deductible for unreimbursed covered expenses 
incurred in prior periods;
    (B) Reasonable lifetime maximum limit on benefits;
    (C) Level premiums;
    (D) Premium waiver during disability;
    (E) Guaranteed policy renewability of coverage, without further 
evidence of insurability (but not guaranty of the amount of premium 
upon renewal);
    (F) Coverage for a specified accidental injury;
    (G) Coverage for a specified disease or illness, including payments 
at initial diagnosis of the specified disease or illness, and 
progressive payments of a set amount per month following the initial 
diagnosis (sometimes referred to as progressive diagnosis payments); 
and
    (H) Payment of a fixed amount per day (or other period) of 
hospitalization.
    (ii) Requirements of permitted benefits. All benefits described in 
paragraph (p)(1)(i) of this section must in addition satisfy all of the 
following requirements--
    (A) No part of any benefit is used in one plan year to purchase a 
benefit in a subsequent plan year;
    (B) The policies remain in force only so long as premiums are 
timely paid on a current basis, and, irrespective of the amount of 
premiums paid in prior plan years, if the current premiums are not 
paid, all coverage for new diseases or illnesses lapses. See paragraph 
(p)(1)(i)(D), allowing premium waiver during disability;
    (C) There is no investment fund or cash value to rely upon for 
payment of premiums; and
    (D) No part of any premium is held in a separate account for any 
participant or beneficiary, or otherwise segregated from the assets of 
the insurance company.
    (2) Benefits under a long-term disability policy relating to more 
than one year. A long-term disability policy paying disability benefits 
over more than one year does not violate the prohibition against 
deferring compensation.
    (3) Reasonable premium rebates or policy dividends. Reasonable 
premium rebates or policy dividends paid with respect to benefits 
provided through a cafeteria plan do not constitute impermissible 
deferred compensation if such rebates or dividends are paid before the 
close of the 12-month period immediately following the cafeteria plan 
year to which such rebates and dividends relate.
    (4) Mandatory two-year election for vision or dental insurance. 
When a cafeteria plan offers vision or dental insurance that requires a 
mandatory two-year coverage period, but not longer (sometimes referred 
to as a ``two-year lock-in''), the mandatory two-year

[[Page 43955]]

coverage period does not result in deferred compensation in violation 
of section 125(d)(2), provided both of the following requirements are 
satisfied--
    (i) The premiums for each plan year are paid no less frequently 
than annually; and
    (ii) In no event does a cafeteria plan use salary reduction or 
flex-credits relating to the first year of a two-year election to apply 
to vision or dental insurance for the second year of the two-year 
election.
    (5) Using salary reduction amounts from one plan year to pay 
accident and health insurance premiums for the first month of the 
immediately following plan year.
    (i) In general. Salary reduction amounts from the last month of one 
plan year of a cafeteria plan may be applied to pay accident and health 
insurance premiums for insurance during the first month of the 
immediately following plan year, if done on a uniform and consistent 
basis with respect to all participants (based on the usual payroll 
interval for each group of participants).
    (ii) Example. The following example illustrates the rules in this 
paragraph (p)(5):

    Example. Salary reduction payments in December of calendar plan 
year to pay accident and health insurance premiums for January. 
Employer S maintains a calendar year cafeteria plan. The cafeteria 
plan offers employees a salary reduction election for accident and 
health insurance. The plan provides that employees' salary reduction 
amounts for the last pay period in December are applied to pay 
accident and health insurance premiums for the immediately following 
January. All employees are paid bi-weekly. For the plan year ending 
December 31, 2009, Employee C elects salary reduction of $3,250 for 
accident and health coverage. For the last pay period in December 
2009, $125 (3,250/26) is applied to the accident and health 
insurance premium for January 2010. This plan provision does not 
violate the prohibition against deferring compensation.

    (q) Nonqualified benefits--(1) In general. The following benefits 
are nonqualified benefits that are not permitted to be offered in a 
cafeteria plan--
    (i) Scholarships described in section 117;
    (ii) Employer-provided meals and lodging described in section 119;
    (iii) Educational assistance described in section 127;
    (iv) Fringe benefits described in section 132;
    (v) Long-term care insurance, or any product which is advertised, 
marketed or offered as long-term care insurance;
    (vi) Long-term care services (but see paragraph (q)(3) of this 
section);
    (vii) Group-term life insurance on the life of any individual other 
than an employee (whether includible or excludible from the employee's 
gross income);
    (viii) Health reimbursement arrangements (HRAs) that provide 
reimbursements up to a maximum dollar amount for a coverage period and 
that all or any unused amount at the end of a coverage period is 
carried forward to increase the maximum reimbursement amount in 
subsequent coverage periods;
    (ix) Contributions to Archer MSAs (section 220); and
    (x) Elective deferrals to a section 403(b) plan.
    (2) Nonqualified benefits not permitted in a cafeteria plan. The 
benefits described in this paragraph (q) are not qualified benefits or 
taxable benefits or cash for purposes of section 125 and thus may not 
be offered in a cafeteria plan regardless of whether any such benefit 
is purchased with after-tax employee contributions or on any other 
basis. A plan that offers a nonqualified benefit is not a cafeteria 
plan. Employees' elections between taxable and nontaxable benefits 
through such plan result in gross income to the participants for any 
benefit elected. See section 125(f). See paragraph (q)(3) of this 
section for special rule on long-term care insurance purchased through 
an HSA.
    (3) Long-term care insurance or services purchased through an HSA. 
Although long-term care insurance is not a qualified benefit and may 
not be offered in a cafeteria plan, a cafeteria plan is permitted to 
offer an HSA as a qualified benefit, and funds from the HSA may be used 
to pay eligible long-term care premiums on a qualified long-term care 
insurance contract or for qualified long-term care services.
    (r) Employer contributions to a cafeteria plan--(1) Salary 
reduction-in general. The term employer contributions means amounts 
that are not currently available (after taking section 125 into 
account) to the employee but are specified in the cafeteria plan as 
amounts that an employee may use for the purpose of electing benefits 
through the plan. A plan may provide that employer contributions may be 
made, in whole or in part, pursuant to employees' elections to reduce 
their compensation or to forgo increases in compensation and to have 
such amounts contributed, as employer contributions, by the employer on 
their behalf. See also Sec.  1.125-5 (flexible spending arrangements). 
Also, a cafeteria plan is permitted to require employees to elect to 
pay the employees' share of any qualified benefit through salary 
reduction and not with after-tax employee contributions. A cafeteria 
plan is also permitted to pay reasonable cafeteria plan administrative 
fees through salary reduction amounts, and these salary reduction 
amounts are excludible from an employee's gross income.
    (2) Salary reduction as employer contribution. Salary reduction 
contributions are employer contributions. An employee's salary 
reduction election is an election to receive a contribution by the 
employer in lieu of salary or other compensation that is not currently 
available to the employee as of the effective date of the election and 
that does not subsequently become currently available to the employee.
    (3) Employer flex-credits. A cafeteria plan may also provide that 
the employer contributions will or may be made on behalf of employees 
equal to (or up to) specified amounts (or specified percentages of 
compensation) and that such nonelective contributions are available to 
employees for the election of benefits through the plan.
    (4) Elective contributions to a section 401(k) plan. See Sec.  
1.401(k)-1 for general rules relating to contributions to section 
401(k) plans.
    (s) Effective/applicability date. It is proposed that these 
regulations apply on and after plan years beginning on or after January 
1, 2009, except that the rule in paragraph (k)(2)(i)(B) of this section 
is effective as of the date the proposed regulations are published in 
the Federal Register.


Sec.  1.125-2  Cafeteria plans; elections.

    (a) Rules relating to making and revoking elections--(1) Elections 
in general. A plan is not a cafeteria plan unless the plan provides in 
writing that employees are permitted to make elections among the 
permitted taxable benefits and qualified benefits offered through the 
plan for the plan year (and grace period, if applicable). All elections 
must be irrevocable by the date described in paragraph (a)(2) of this 
section except as provided in paragraph (a)(4) of this section. An 
election is not irrevocable if, after the earlier of the dates 
specified in paragraph (a)(2) of this section, employees have the right 
to revoke their elections of qualified benefits and instead receive the 
taxable benefits for such period, without regard to whether the 
employees actually revoke their elections.
    (2) Timing of elections. In order for employees to exclude 
qualified benefits from employees' gross income, benefit

[[Page 43956]]

elections in a cafeteria plan must be made before the earlier of--
    (i) The date when taxable benefits are currently available; or
    (ii) The first day of the plan year (or other coverage period).
    (3) Benefit currently available to an employee-in general. Cash or 
another taxable benefit is currently available to the employee if it 
has been paid to the employee or if the employee is able currently to 
receive the cash or other taxable benefit at the employee's discretion. 
However, cash or another taxable benefit is not currently available to 
an employee if there is a significant limitation or restriction on the 
employee's right to receive the benefit currently. Similarly, a benefit 
is not currently available as of a date if the employee may under no 
circumstances receive the benefit before a particular time in the 
future. The determination of whether a benefit is currently available 
to an employee does not depend on whether it has been constructively 
received by the employee for purposes of section 451.
    (4) Exceptions to rule on making and revoking elections. If a 
cafeteria plan incorporates the change in status rules in Sec.  1.125-
4, to the extent provided in those rules, an employee who experiences a 
change in status (as defined in Sec.  1.125-4) is permitted to revoke 
an existing election and to make a new election with respect to the 
remaining portion of the period of coverage, but only with respect to 
cash or other taxable benefits that are not yet currently available. 
See paragraph (c)(1) of this section for a special rule for changing 
elections prospectively for HSA contributions and paragraph (r)(4) in 
Sec.  1.125-1 for section 401(k) elections. Also, only an employee of 
the employer sponsoring a cafeteria plan is allowed to make, revoke or 
change elections in the employer's cafeteria plan. The employee's 
spouse, dependent or any other individual other than the employee may 
not make, revoke or change elections under the plan.
    (5) Elections not required on written paper documents. A cafeteria 
plan does not fail to meet the requirements of section 125 merely 
because it permits employees to use electronic media for such 
transactions. The safe harbor in Sec.  1.401(a)-21 applies to 
electronic elections, revocations and changes in elections under 
section 125.
    (6) Examples. The following examples illustrate the rules in this 
paragraph (a):

    Example 1. Election not revocable during plan year. Employer A's 
cafeteria plan offers each employee the opportunity to elect, for a 
plan year, between $5,000 cash for the plan year and a dependent 
care assistance program of up to $5,000 of dependent care expenses 
incurred by the employee during the plan year. The cafeteria plan 
requires employees to elect between these benefits before the 
beginning of the plan year. After the year has commenced, employees 
are prohibited from revoking their elections. The cafeteria plan 
allows revocation of elections based on changes in status (as 
described in Sec.  1.125-4). Employees who elected the dependent 
care assistance program do not include the $5,000 cash in gross 
income. The cafeteria plan satisfies the requirements in this 
paragraph (a).
    Example 2. Election revocable during plan year. Same facts as 
Example 1 except that Employer A's cafeteria plan allows employees 
to revoke their elections for dependent care assistance at any time 
during the plan year and receive the unused amount of dependent care 
assistance as cash. The cafeteria plan fails to satisfy the 
requirements in this paragraph (a), and is not a cafeteria plan. All 
employees are treated as having received the $5,000 in cash even if 
they do not revoke their elections. The same result occurs even 
though the cash is not payable until the end of the plan year.

    (b) Automatic elections--(1) In general. For new employees or 
current employees who fail to timely elect between permitted taxable 
benefits and qualified benefits, a cafeteria plan is permitted, but is 
not required, to provide default elections for one or more qualified 
benefits (for example, an election made for any prior year is deemed to 
be continued for every succeeding plan year, unless changed).
    (2) Example. The following example illustrates the rules in this 
paragraph (b):

    Example. Automatic elections for accident and health insurance. 
(i) Employer B maintains a calendar year cafeteria plan. The 
cafeteria plan offers accident and health insurance with an option 
for employee-only or family coverage. All employees are eligible to 
participate in the cafeteria plan immediately upon hire.
    (ii) The cafeteria plan provides for an automatic enrollment 
process: Each new employee and each current employee is 
automatically enrolled in employee-only coverage under the accident 
and health insurance plan, and the employee's salary is reduced to 
pay the employee's share of the accident and health insurance 
premium, unless the employee affirmatively elects cash. 
Alternatively, if the employee has a spouse or child, the employee 
can elect family coverage.
    (iii) When an employee is hired, the employee receives a notice 
explaining the automatic enrollment process and the employee's right 
to decline coverage and have no salary reduction. The notice 
includes the salary reduction amounts for employee-only coverage and 
family coverage, procedures for exercising the right to decline 
coverage, information on the time by which an election must be made, 
and the period for which an election is effective. The notice is 
also given to each current employee before the beginning of each 
subsequent plan year, except that the notice for a current employee 
includes a description of the employee's existing coverage, if any.
    (iv) For a new employee, an election to receive cash or to have 
family coverage rather than employee-only coverage is effective if 
made when the employee is hired. For a current employee, an election 
is effective if made prior to the start of each calendar year or 
under any other circumstances permitted under Sec.  1.125-4. An 
election made for any prior year is deemed to be continued for every 
succeeding plan year, unless changed.
    (v) Contributions used to purchase accident and health insurance 
through a cafeteria plan are not includible in the gross income of 
the employee solely because the plan provides for automatic 
enrollment as a default election whereby the employee's salary is 
reduced each year to pay for a portion of the accident and health 
insurance through the plan (unless the employee affirmatively elects 
cash).

    (c) Election rules for salary reduction contributions to HSAs--(1) 
Prospective elections and changes in salary reduction elections 
allowed. Contributions may be made to an HSA through a cafeteria plan. 
A cafeteria plan offering HSA contributions through salary reduction 
may permit employees to make prospective salary reduction elections or 
change or revoke salary reduction elections for HSA contributions (for 
example, to increase or decrease salary reduction elections for HSA 
contributions) at any time during the plan year, effective before 
salary becomes currently available. If a cafeteria plan offers HSA 
contributions as a qualified benefit, the plan must--
    (i) Specifically describe the HSA contribution benefit;
    (ii) Allow a participant to prospectively change his or her salary 
reduction election for HSA contributions on a monthly basis (or more 
frequently); and
    (iii) Allow a participant who becomes ineligible to make HSA 
contributions to prospectively revoke his or her salary reduction 
election for HSA contributions.
    (2) Example. The following example illustrates the rules in this 
paragraph (c):

    Example. Prospective HSA salary reduction elections. (i) A 
cafeteria plan with a calendar plan year allows employees to make 
salary reduction elections for HSA contributions through the plan. 
The cafeteria plan permits employees to prospectively make, change 
or revoke salary contribution elections for HSA contributions, 
limited to one election, change or revocation per month.
    (ii) Employee M participates in the cafeteria plan. Before 
salary becomes currently available to M, M makes the following 
elections. On January 2, 2009, M elects to contribute $100 for each 
pay period to an HSA, effective January 3, 2009. On

[[Page 43957]]

March 15, 2009, M elects to reduce the HSA contribution to $35 per 
pay period, effective April 1, 2009. On May 1, 2009, M elects to 
discontinue all HSA contributions, effective May 15, 2009. The 
cafeteria plan implements all of Employee M's elections,
    (iii) The cafeteria plan's operation is consistent with the 
section 125 election, change and revocation rules for HSA 
contributions.

    (d) Optional election for new employees. A cafeteria plan may 
provide new employees 30 days after their hire date to make elections 
between cash and qualified benefits. The election is effective as of 
the employee's hire date. However, salary reduction amounts used to pay 
for such an election must be from compensation not yet currently 
available on the date of the election. The written cafeteria plan must 
provide that any employee who terminates employment and is rehired 
within 30 days after terminating employment (or who returns to 
employment following an unpaid leave of absence of less than 30 days) 
is not a new employee eligible for the election in this paragraph (d).
    (e) Effective/applicability date. It is proposed that these 
regulations apply on and after plan years beginning on or after January 
1, 2009.
    Par. 3. Sections 1.125-5, 1.125-6 and 1.125-7 are added to read as 
follows:


Sec.  1.125-5  Flexible spending arrangements.

    (a) Definition of flexible spending arrangement--(1) In general. An 
FSA generally is a benefit program that provides employees with 
coverage which reimburses specified, incurred expenses (subject to 
reimbursement maximums and any other reasonable conditions). An expense 
for qualified benefits must not be reimbursed from the FSA unless it is 
incurred during a period of coverage. See paragraph (e) of this 
section. After an expense for a qualified benefit has been incurred, 
the expense must first be substantiated before the expense is 
reimbursed. See paragraphs (a) through (f) in Sec.  1.125-6.
    (2) Maximum amount of reimbursement. The maximum amount of 
reimbursement that is reasonably available to an employee for a period 
of coverage must not be substantially in excess of the total salary 
reduction and employer flex-credit for such participant's coverage. A 
maximum amount of reimbursement is not substantially in excess of the 
total salary reduction and employer flex-credit if such maximum amount 
is less than 500 percent of the combined salary reduction and employer 
flex-credit. A single FSA may provide participants with different 
levels of coverage and maximum amounts of reimbursement. See paragraph 
(r) in Sec.  1.125-1 and paragraphs (b) and (d) in this section for the 
definition of salary reduction, employer flex-credit, and uniform 
coverage rule.
    (b) Flex-credits allowed--(1) In general. An FSA in a cafeteria 
plan must include an election between cash or taxable benefits 
(including salary reduction) and one or more qualified benefits, and 
may include, in addition, ``employer flex-credits.'' For this purpose, 
flex-credits are non-elective employer contributions that the employer 
makes for every employee eligible to participate in the employer's 
cafeteria plan, to be used at the employee's election only for one or 
more qualified benefits (but not as cash or a taxable benefit). See 
Sec.  1.125-1 for definitions of qualified benefits, cash and taxable 
benefits.
    (2) Example. The following example illustrates the rules in this 
paragraph (b):

    Example. Flex-credit. Contribution to health FSA for employees 
electing employer-provided accident and health plan. Employer A 
maintains a cafeteria plan offering employees an election between 
cash or taxable benefits and premiums for employer-provided accident 
and health insurance or coverage through an HMO. The plan also 
provides an employer contribution of $200 to the health FSA of every 
employee who elects accident and health insurance or HMO coverage. 
In addition, these employees may elect to reduce their salary to 
make additional contributions to their health FSAs. The benefits 
offered in this cafeteria plan are consistent with the requirements 
of section 125 and this paragraph (b).

    (c) Use-or-lose rule--(1) In general. An FSA may not defer 
compensation. No contribution or benefit from an FSA may be carried 
over to any subsequent plan year or period of coverage. See paragraph 
(k)(3) in this section for specific exceptions. Unused benefits or 
contributions remaining at the end of the plan year (or at the end of a 
grace period, if applicable) are forfeited.
    (2) Example. The following example illustrates the rules in this 
paragraph (c):

    Example. Use-or-lose rule. (i) Employer B maintains a calendar 
year cafeteria plan, offering an election between cash and a health 
FSA. The cafeteria plan has no grace period.
    (ii) Employee A plans to have eye surgery in 2009. For the 2009 
plan year, Employee A timely elects salary reduction of $3,000 for a 
health FSA. During the 2009 plan year, Employee A learns that she 
cannot have eye surgery performed, but incurs other section 213(d) 
medical expenses totaling $1,200. As of December 31, 2009, she has 
$1,800 of unused benefits and contributions in the health FSA. 
Consistent with the rules in this paragraph (c), she forfeits 
$1,800.

    (d) Uniform coverage rules applicable to health FSAs--(1) Uniform 
coverage throughout coverage period--in general. The maximum amount of 
reimbursement from a health FSA must be available at all times during 
the period of coverage (properly reduced as of any particular time for 
prior reimbursements for the same period of coverage). Thus, the 
maximum amount of reimbursement at any particular time during the 
period of coverage cannot relate to the amount that has been 
contributed to the FSA at any particular time prior to the end of the 
plan year. Similarly, the payment schedule for the required amount for 
coverage under a health FSA may not be based on the rate or amount of 
covered claims incurred during the coverage period. Employees' salary 
reduction payments must not be accelerated based on employees' incurred 
claims and reimbursements.
    (2) Reimbursement available at all times. Reimbursement is deemed 
to be available at all times if it is paid at least monthly or when the 
total amount of the claims to be submitted is at least a specified, 
reasonable minimum amount (for example, $50).
    (3) Terminated participants. When an employee ceases to be a 
participant, the cafeteria plan must pay the former participant any 
amount the former participant previously paid for coverage or benefits 
to the extent the previously paid amount relates to the period from the 
date the employee ceases to be a participant through the end of that 
plan year. See paragraph (e)(2) in this section for COBRA elections for 
health FSAs.
    (4) Example. The following example illustrates the rules in this 
paragraph (d):

    Example. Uniform coverage. (i) Employer C maintains a calendar 
year cafeteria plan, offering an election between cash and a health 
FSA. The cafeteria plan prohibits accelerating employees' salary 
reduction payments based on employees' incurred claims and 
reimbursements.
    (ii) For the 2009 plan year, Employee N timely elects salary 
reduction of $3,000 for a health FSA. Employee N pays the $3,000 
salary reduction amount through salary reduction of $250 per month 
throughout the coverage period. Employee N is eligible to receive 
the maximum amount of reimbursement of $3,000 at all times 
throughout the coverage period (reduced by prior reimbursements).
    (iii) N incurs $2,500 of section 213(d) medical expenses in 
January, 2009. The full $2,500 is reimbursed although Employee N has 
made only one salary reduction payment of $250. N incurs $500 in 
medical expenses in February, 2009. The remaining $500 of the $3,000 
is reimbursed. After Employee N submits a claim for reimbursement 
and substantiates the medical expenses, the cafeteria plan 
reimburses N for the $2,500

[[Page 43958]]

and $500 medical expenses. Employer C's cafeteria plan satisfies the 
uniform coverage rule.

    (5) No uniform coverage rule for FSAs for dependent care assistance 
or adoption assistance. The uniform coverage rule applies only to 
health FSAs and does not apply to FSAs for dependent care assistance or 
adoption assistance. See paragraphs (i) and (j) of this section for the 
rules for FSAs for dependent care assistance and adoption assistance.
    (e) Required period of coverage for a health FSA, dependent care 
FSA and adoption assistance FSA--(1) Twelve-month period of coverage--
in general. An FSA's period of coverage must be 12 months. However, in 
the case of a short plan year, the period of coverage is the entire 
short plan year. See paragraph (d) in Sec.  1.125-1 for rules on plan 
years and changing plan years.
    (2) COBRA elections for health FSAs. For the application of the 
health care continuation rules of section 4980B of the Code to health 
FSAs, see Q & A-2 in Sec.  54.4980B-2 of this chapter.
    (3) Separate period of coverage permitted for each qualified 
benefit offered through FSA. Dependent care assistance, adoption 
assistance, and a health FSA are each permitted to have a separate 
period of coverage, which may be different from the plan year of the 
cafeteria plan.
    (f) Coverage on a month-by-month or expense-by-expense basis 
prohibited. In order for reimbursements from an accident and health 
plan to qualify for the section 105(b) exclusion, an employer-funded 
accident and health plan offered through a cafeteria plan may not 
operate in a manner that enables employees to purchase the accident and 
health plan coverage only for periods when employees expect to incur 
medical care expenses. Thus, for example, if a cafeteria plan permits 
employees to receive accident and health plan coverage on a month-by-
month or an expense-by-expense basis, reimbursements from the accident 
and health plan fail to qualify for the section 105(b) exclusion. If, 
however, the period of coverage under an accident and health plan 
offered through a cafeteria plan is twelve months and the cafeteria 
plan does not permit an employee to elect specific amounts of coverage, 
reimbursement, or salary reduction for less than twelve months, the 
cafeteria plan does not operate to enable participants to purchase 
coverage only for periods during which medical care will be incurred. 
See Sec.  1.125-4 and paragraph (a) in Sec.  1.125-2 regarding the 
revocation of elections during a period of coverage on account of 
changes in family status.
    (g) FSA administrative practices--(1) Limiting health FSA 
enrollment to employees who participate in the employer's accident and 
health plan. At the employer's option, a cafeteria plan is permitted to 
provide that only those employees who participate in one or more 
specified employer-provided accident and health plans may participate 
in a health FSA. See Sec.  1.125-7 for nondiscrimination rules.
    (2) Interval for employees' salary reduction contributions. The 
cafeteria plan is permitted to specify any interval for employees' 
salary reduction contributions. The interval specified in the plan must 
be uniform for all participants.
    (h) Qualified benefits permitted to be offered through an FSA. 
Dependent care assistance (section 129), adoption assistance (section 
137) and a medical reimbursement arrangement (section 105(b)) are 
permitted to be offered through an FSA in a cafeteria plan.
    (i) Section 129 rules for dependent care assistance program offered 
through a cafeteria plan--(1) General rule. In order for dependent care 
assistance to be a qualified benefit that is excludible from gross 
income if elected through a cafeteria plan, the cafeteria plan must 
satisfy section 125 and the dependent care assistance must satisfy 
section 129.
    (2) Dependent care assistance in general. Section 129(a) provides 
an employee with an exclusion from gross income both for an employer-
funded dependent care assistance program and for amounts paid or 
incurred by the employer for dependent care assistance provided to the 
employee, if the amounts are paid or incurred through a dependent care 
assistance program. See paragraph (a)(4) in Sec.  1.125-6 on when 
dependent care expenses are incurred.
    (3) Reimbursement exclusively for dependent care assistance. A 
dependent care assistance program may not provide reimbursements other 
than for dependent care expenses; in particular, if an employee has 
dependent care expenses less than the amount specified by salary 
reduction, the plan may not provide other taxable or nontaxable 
benefits for any portion of the specified amount not used for the 
reimbursement of dependent care expenses. Thus, if an employee has 
elected coverage under the dependent care assistance program and the 
period of coverage has commenced, the employee must not have the right 
to receive amounts from the program other than as reimbursements for 
dependent care expenses. This is the case regardless of whether 
coverage under the program is purchased with contributions made at the 
employer's discretion, at the employee's discretion, or pursuant to a 
collective bargaining agreement. Arrangements formally outside of the 
cafeteria plan providing for the adjustment of an employee's 
compensation or an employee's receipt of any other benefits on the 
basis of the assistance or reimbursements received by the employee are 
considered in determining whether a dependent care benefit is a 
dependent care assistance program under section 129.
    (j) Section 137 rules for adoption assistance program offered 
through a cafeteria plan--(1) General rule. In order for adoption 
assistance to be a qualified benefit that is excludible from gross 
income if elected through a cafeteria plan, the cafeteria plan must 
satisfy section 125 and the adoption assistance must satisfy section 
137.
    (2) Adoption assistance in general. Section 137(a) provides an 
employee with an exclusion from gross income for amounts paid or 
expenses incurred by the employer for qualified adoption expenses in 
connection with an employee's adoption of a child, if the amounts are 
paid or incurred through an adoption assistance program. Certain limits 
on amount of expenses and employee's income apply.
    (3) Reimbursement exclusively for adoption assistance. Rules and 
requirements similar to the rules and requirements in paragraph (i)(3) 
of this section for dependent care assistance apply to adoption 
assistance.
    (k) FSAs and the rules governing the tax-favored treatment of 
employer-provided health benefits--(1) Medical expenses. Health plans 
that are flexible spending arrangements, as defined in paragraph (a)(1) 
of this section, must conform to the generally applicable rules under 
sections 105 and 106 in order for the coverage and reimbursements under 
such plans to qualify for tax-favored treatment under such sections. 
Thus, health FSAs must qualify as accident and health plans. See 
paragraph (n) in Sec.  1.125-1. A health FSA is only permitted to 
reimburse medical expenses as defined in section 213(d). Thus, for 
example, a health FSA is not permitted to reimburse dependent care 
expenses.
    (2) Limiting payment or reimbursement to certain section 213(d) 
medical expenses. A health FSA is permitted to limit payment or 
reimbursement to only certain section 213(d) medical expenses (except 
health insurance, long-term care services or insurance). See paragraph 
(q) in Sec.  1.125-1. For example, a health FSA in a cafeteria plan is 
permitted to provide in

[[Page 43959]]

the written plan that the plan reimburses all section 213(d) medical 
expenses allowed to be paid or reimbursed under a cafeteria plan except 
over-the-counter drugs.
    (3) Application of prohibition against deferred compensation to 
medical expenses--(i) Certain advance payments for orthodontia 
permitted. A cafeteria plan is permitted, but is not required to, 
reimburse employees for orthodontia services before the services are 
provided but only to the extent that the employee has actually made the 
payments in advance of the orthodontia services in order to receive the 
services. These orthodontia services are deemed to be incurred when the 
employee makes the advance payment. Reimbursing advance payments does 
not violate the prohibition against deferring compensation.
    (ii) Example. The following example illustrates the rules in 
paragraph (k)(3):

    Example. Advance payment to orthodontist. Employer D sponsors a 
calendar year cafeteria plan which offers a health FSA. Employee K 
elects to salary reduce $3,000 for a health FSA for the 2009 plan 
year. Employee K's dependent requires orthodontic treatment. K's 
accident and health insurance does not cover orthodontia. The 
orthodontist, following the normal practice, charges $3,000, all due 
in 2009, for treatment, to begin in 2009 and end in 2010. K pays the 
$3,000 in 2009. In 2009, Employer D's cafeteria plan may reimburse 
$3,000 to K, without violating the prohibition against deferring 
compensation in section 125(d)(2).

    (iii) Reimbursements for durable medical equipment. A health FSA in 
a cafeteria plan that reimburses employees for equipment (described in 
section 213(d)) with a useful life extending beyond the period of 
coverage during which the expense is incurred does not provide deferred 
compensation. For example, a health FSA is permitted to reimburse the 
cost of a wheelchair for an employee.
    (4) No reimbursement of premiums for accident and health insurance 
or long-term care insurance or services. A health FSA is not permitted 
to treat employees' premium payments for other health coverage as 
reimbursable expenses. Thus, for example, a health FSA is not permitted 
to reimburse employees for payments for other health plan coverage, 
including premiums for COBRA coverage, accidental death and 
dismemberment insurance, long-term disability or short-term disability 
insurance or for health coverage under a plan maintained by the 
employer of the employee or the employer of the employee's spouse or 
dependent. Also, a health FSA is not permitted to reimburse expenses 
for long-term care insurance premiums or for long-term care services 
for the employee or employee's spouse or dependent. See paragraph (q) 
in Sec.  1.125-1 for nonqualified benefits
    (l) Section 105(h) requirements. Section 105(h) applies to health 
FSAs. Section 105(h) provides that the exclusion provided by section 
105(b) is not available with respect to certain amounts received by a 
highly compensated individual (as defined in section 105(h)(5)) from a 
discriminatory self-insured medical reimbursement plan, which includes 
health FSAs. See Sec.  1.105-11. For purposes of section 105(h), 
coverage by a self-insured accident and health plan offered through a 
cafeteria plan is an optional benefit (even if only one level and type 
of coverage is offered) and, for purposes of the optional benefit rule 
in Sec.  1.105-11(c)(3)(i), employer contributions are treated as 
employee contributions to the extent that taxable benefits are offered 
by the plan.
    (m) HSA-compatible FSAs-limited-purpose health FSAs and post-
deductible health FSAs--(1) In general. Limited-purpose health FSAs and 
post-deductible health FSAs which satisfy all the requirements of 
section 125 are permitted to be offered through a cafeteria plan.
    (2) HSA-compatible FSAs. Section 223(a) allows a deduction for 
certain contributions to a ``Health Savings Account'' (HSA) (as defined 
in section 223(d)). An eligible individual (as defined in section 
223(c)(1)) may contribute to an HSA. An eligible individual must be 
covered under a ``high deductible health plan'' (HDHP) and not, while 
covered under an HDHP, under any health plan which is not an HDHP. A 
general purpose health FSA is not an HDHP and an individual covered by 
a general purpose health FSA is not eligible to contribute to an HSA. 
However, an individual covered by an HDHP (and who otherwise satisfies 
section 223(c)(1)) does not fail to be an eligible individual merely 
because the individual is also covered by a limited-purpose health FSA 
or post-deductible health FSA (as defined in this paragraph (m)) or a 
combination of a limited-purpose health FSA and a post-deductible 
health FSA.
    (3) Limited-purpose health FSA. A limited-purpose health FSA is a 
health FSA described in the cafeteria plan that only pays or reimburses 
permitted coverage benefits (as defined in section 223(c)(2)(C)), such 
as vision care, dental care or preventive care (as defined for purposes 
of section 223(c)(2)(C)). See paragraph (k) in this section.
    (4) Post-deductible health FSA--(i) In general. A post-deductible 
health FSA is a health FSA described in the cafeteria plan that only 
pays or reimburses medical expenses (as defined in section 213(d)) for 
preventive care or medical expenses incurred after the minimum annual 
HDHP deductible under section 223(c)(2)(A)(i) is satisfied. See 
paragraph (k) in this section. No medical expenses incurred before the 
annual HDHP deductible is satisfied may be reimbursed by a post-
deductible FSA, regardless of whether the HDHP covers the expense or 
whether the deductible is later satisfied. For example, even if 
chiropractic care is not covered under the HDHP, expenses for 
chiropractic care incurred before the HDHP deductible is satisfied are 
not reimbursable at any time by a post-deductible health FSA.
    (ii) HDHP and health FSA deductibles. The deductible for a post-
deductible health FSA need not be the same amount as the deductible for 
the HDHP, but in no event may the post-deductible health FSA or other 
coverage provide benefits before the minimum annual HDHP deductible 
under section 223(c)(2)(A)(i) is satisfied (other than benefits 
permitted under a limited-purpose health FSA). In addition, although 
the deductibles of the HDHP and the other coverage may be satisfied 
independently by separate expenses, no benefits may be paid before the 
minimum annual deductible under section 223(c)(2)(A)(i) has been 
satisfied. An individual covered by a post-deductible health FSA (if 
otherwise an eligible individual) is an eligible individual for the 
purpose of contributing to the HSA.
    (5) Combination of limited-purpose health FSA and post-deductible 
health FSA. An FSA is a combination of a limited-purpose health FSA and 
post-deductible health FSA if each of the benefits and reimbursements 
provided under the FSA are permitted under either a limited-purpose 
health FSA or post-deductible health FSA. For example, before the HDHP 
deductible is satisfied, a combination limited-purpose and post-
deductible health FSA may reimburse only preventive, vision or dental 
expenses. A combination limited-purpose and post-deductible health FSA 
may also reimburse any medical expense that may otherwise be paid by an 
FSA (that is, no insurance premiums or long-term care benefits) that is 
incurred after the HDHP deductible is satisfied.
    (6) Substantiation. The substantiation rules in this section apply 
to limited-purpose health FSAs and to post-deductible health FSAs. In 
addition to

[[Page 43960]]

providing third-party substantiation of medical expenses, a participant 
in a post-deductible health FSA must provide information from an 
independent third party that the HDHP deductible has been satisfied. A 
participant in a limited-purpose health FSA must provide information 
from an independent third-party that the medical expenses are for 
vision care, dental care or preventive care.
    (7) Plan amendments. See paragraph (c) in Sec.  1.125-1 on the 
required effective date for amendments adopting or changing limited-
purpose, post-deductible or combination limited-purpose and post-
deductible health FSAs.
    (n) Qualified HSA distributions--(1) In general. A health FSA in a 
cafeteria plan is permitted to offer employees the right to elect 
qualified HSA distributions described in section 106(e). No qualified 
HSA distribution may be made in a plan year unless the employer amends 
the health FSA written plan with respect to all employees, effective by 
the last day of the plan year, to allow a qualified HSA distribution 
satisfying all the requirements in this paragraph (n). See also section 
106(e)(5)(B). In addition, a distribution with respect to an employee 
is not a qualified HSA distribution unless all of the following 
requirements are satisfied--
    (i) No qualified HSA distribution has been previously made on 
behalf of the employee from this health FSA;
    (ii) The employee elects to have the employer make a qualified HSA 
distribution from the health FSA to the HSA of the employee;
    (iii) The distribution does not exceed the lesser of the balance of 
the health FSA on--
    (A) September 21, 2006; or
    (B) The date of the distribution;
    (iv) For purposes of this paragraph (n)(1), balances as of any date 
are determined on a cash basis, without taking into account expenses 
incurred but not reimbursed as of a date, and applying the uniform 
coverage rule in paragraph (d) in this section;
    (v) The distribution is made no later than December 31, 2011; and
    (vi) The employer makes the distribution directly to the trustee of 
the employee's HSA.
    (2) Taxation of qualified HSA distributions. A qualified HSA 
distribution from the health FSA covering the participant to his or her 
HSA is a rollover to the HSA (as defined in section 223(f)(5)) and thus 
is generally not includible in gross income. However, if the 
participant is not an eligible individual (as defined in section 
223(c)(1)) at any time during a testing period following the qualified 
HSA distribution, the amount of the distribution is includible in the 
participant's gross income and he or she is also subject to an 
additional 10 percent tax (with certain exceptions). Section 106(e)(3).
    (3) No effect on health FSA elections, coverage, use-or-lose rule. 
A qualified HSA distribution does not alter an employee's irrevocable 
election under paragraph (a) of Sec.  1.125-2, or constitute a change 
in status under Sec.  1.125-4(a). If a qualified HSA distribution is 
made to an employee's HSA, even if the balance in a health FSA is 
reduced to zero, the employee's health FSA coverage continues to the 
end of the plan year. Unused benefits and contributions remaining at 
the end of a plan year (or at the end of a grace period, if applicable) 
must be forfeited.
    (o) FSA experience gains or forfeitures--(1) Experience gains in 
general. An FSA experience gain (sometimes referred to as forfeitures 
in the use-or-lose rule in paragraph (c) in this section) with respect 
to a plan year (plus any grace period following the end of a plan year 
described in paragraph (e) in Sec.  1.125-1), equals the amount of the 
employer contributions, including salary reduction contributions, and 
after-tax employee contributions to the FSA minus the FSA's total 
claims reimbursements for the year. Experience gains (or forfeitures) 
may be--
    (i) Retained by the employer maintaining the cafeteria plan; or
    (ii) If not retained by the employer, may be used only in one or 
more of the following ways--
    (A) To reduce required salary reduction amounts for the immediately 
following plan year, on a reasonable and uniform basis, as described in 
paragraph (o)(2) of this section;
    (B) Returned to the employees on a reasonable and uniform basis, as 
described in paragraph (o)(2) of this section; or
    (C) To defray expenses to administer the cafeteria plan.
    (2) Allocating experience gains among employees on reasonable and 
uniform basis. If not retained by the employer or used to defray 
expenses of administering the plan, the experience gains must be 
allocated among employees on a reasonable and uniform basis. It is 
permissible to allocate these amounts based on the different coverage 
levels of employees under the FSA. Experience gains allocated in 
compliance with this paragraph (o) are not a deferral of the receipt of 
compensation. However, in no case may the experience gains be allocated 
among employees based (directly or indirectly) on their individual 
claims experience. Experience gains may not be used as contributions 
directly or indirectly to any deferred compensation benefit plan.
    (3) Example. The following example illustrates the rules in this 
paragraph (o):

    Example. Allocating experience gains. (i) Employer L maintains a 
cafeteria plan for its 1,200 employees, who may elect one of several 
different annual coverage levels under a health FSA in $100 
increments from $500 to $2,000.
    (ii) For the 2009 plan year, 1,000 employees elect levels of 
coverage under the health FSA. For the 2009 plan year, the health 
FSA has an experience gain of $5,000.
    (iii) The $5,000 may be allocated to all participants for the 
plan year on a per capita basis weighted to reflect the 
participants' elected levels of coverage.
    (iv) Alternatively, the $5,000 may be used to reduce the 
required salary reduction amount under the health FSA for all 2009 
participants (for example, a $500 health FSA for the next year is 
priced at $480) or to reimburse claims incurred above the elective 
limit in 2010 as long as such reimbursements are made on a 
reasonable and uniform level.

    (p) Effective/applicability date. It is proposed that these 
regulations apply on and after plan years beginning on or after January 
1, 2009.


Sec.  1.125-6  Substantiation of expenses for all cafeteria plans.

    (a) Cafeteria plan payments and reimbursements--(1) In general. A 
cafeteria plan may pay or reimburse only those substantiated expenses 
for qualified benefits incurred on or after the later of the effective 
date of the cafeteria plan and the date the employee is enrolled in the 
plan. This requirement applies to all qualified benefits offered 
through the cafeteria plan. See paragraph (b) of this section for 
substantiation rules.
    (2) Expenses incurred--(i) Employees' medical expenses must be 
incurred during the period of coverage. In order for reimbursements to 
be excludible from gross income under section 105(b), the medical 
expenses reimbursed by an accident and health plan elected through a 
cafeteria plan must be incurred during the period when the participant 
is covered by the accident and health plan. A participant's period of 
coverage includes COBRA coverage. See Sec.  54.4980B-2 of this chapter. 
Medical expenses incurred before the later of the effective date of the 
plan and the date the employee is enrolled in the plan are not incurred 
during the period for which the employee is covered by the plan. 
However, the actual reimbursement of covered medical care expenses may 
be made after the applicable period of coverage.

[[Page 43961]]

    (ii) When medical expenses are incurred. For purposes of this rule, 
medical expenses are incurred when the employee (or the employee's 
spouse or dependents) is provided with the medical care that gives rise 
to the medical expenses, and not when the employee is formally billed, 
charged for, or pays for the medical care.
    (iii) Example. The following example illustrates the rules in this 
paragraph (a)(2):

    Example. Medical expenses incurred after termination. (i) 
Employer E maintains a cafeteria plan with a calendar year plan 
year. The cafeteria plan provides that participation terminates when 
an individual ceases to be an employee of Employer E, unless the 
former employee elects to continue to participate in the health FSA 
under the COBRA rules in Sec.  54.4980B-2 of this chapter. Employee 
G timely elects to salary reduce $1,200 to participate in a health 
FSA for the 2009 plan year. As of June 30, 2009, Employee G has 
contributed $600 toward the health FSA, but incurred no medical 
expenses. On June 30, 2009, Employee G terminates employment and 
does not continue participation under COBRA. On July 15, 2009, G 
incurs a section 213(d) medical expense of $500.
    (ii) Under the rules in paragraph (a)(2) of this section, the 
cafeteria plan is prohibited from reimbursing any portion of the 
$500 medical expense because, at the time the medical expense is 
incurred, G is not a participant in the cafeteria plan.

    (3) Section 105(b) requirements for reimbursement of medical 
expenses through a cafeteria plan--(i) In general. In order for medical 
care reimbursements paid to an employee through a cafeteria plan to be 
excludible under section 105(b), the reimbursements must be paid 
pursuant to an employer-funded accident and health plan, as defined in 
section 105(e) and Sec. Sec.  1.105-2 and 1.105-5.
    (ii) Reimbursement exclusively for section 213(d) medical expenses. 
A cafeteria plan benefit through which an employee receives 
reimbursements of medical expenses is excludable under section 105(b) 
only if reimbursements from the plan are made specifically to reimburse 
the employee for medical expenses (as defined in section 213(d)) 
incurred by the employee or the employee's spouse or dependents during 
the period of coverage. Amounts paid to an employee as reimbursement 
are not paid specifically to reimburse the employee for medical 
expenses if the plan provides that the employee is entitled, or 
operates in a manner that entitles the employee, to receive the 
amounts, in the form of cash (for example, routine payment of salary) 
or any other taxable or nontaxable benefit irrespective of whether the 
employee (or the employee's spouse or dependents) incurs medical 
expenses during the period of coverage. This rule applies even if the 
employee will not receive such amounts until the end or after the end 
of the period. A plan under which employees (or their spouses and 
dependents) will receive reimbursement for medical expenses up to a 
specified amount and, if they incur no medical expenses, will receive 
cash or any other benefit in lieu of the reimbursements is not a 
benefit qualifying for the exclusion under sections 106 and 105(b). See 
Sec.  1.105-2. This is the case without regard to whether the benefit 
was purchased with contributions made at the employer's discretion, at 
the employee's discretion (for example, by salary reduction election), 
or pursuant to a collective bargaining agreement.
    (iii) Other arrangements. Arrangements formally outside of the 
cafeteria plan that adjust an employee's compensation or an employee's 
receipt of any other benefits on the basis of the expenses incurred or 
reimbursements the employee receives are considered in determining 
whether the reimbursements are through a plan eligible for the 
exclusions under sections 106 and 105(b).
    (4) Reimbursements of dependent care expenses--(i) Dependent care 
expenses must be incurred. In order to satisfy section 129, dependent 
care expenses may not be reimbursed before the expenses are incurred. 
For purposes of this rule, dependent care expenses are incurred when 
the care is provided and not when the employee is formally billed, 
charged for, or pays for the dependent care.
    (ii) Dependent care provided during the period of coverage. In 
order for dependent care assistance to be provided through a dependent 
care assistance program eligible for the section 129 exclusion, the 
care must be provided to or on behalf of the employee during the period 
for which the employee is covered by the program. For example, if for a 
plan year, an employee elects a dependent care assistance program 
providing for reimbursement of dependent care expenses, only 
reimbursements for dependent care expenses incurred during that plan 
year are provided from a dependent care assistance program within the 
scope of section 129. Also, for purposes of this rule, expenses 
incurred before the later of the program's effective date and the date 
the employee is enrolled in the program are not incurred during the 
period when the employee is covered by the program. Similarly, if the 
dependent care assistance program furnishes the dependent care in-kind 
(for example, through an employer-maintained child care facility), only 
dependent care provided during the plan year of coverage is provided 
through a dependent care assistance program within the meaning of 
section 129. See also Sec.  1.125-5 for FSA rules.
    (iii) Period of coverage. In order for dependent care assistance 
through a cafeteria plan to be provided through a dependent care 
assistance program eligible for the section 129 exclusion, the plan may 
not operate in a manner that enables employees to purchase dependent 
care assistance only for periods during which the employees expect to 
receive dependent care assistance. If the period of coverage for a 
dependent care assistance program offered through a cafeteria plan is 
twelve months (or, in the case of a short plan year, at least equal to 
the short plan year) and the plan does not permit an employee to elect 
specific amounts of coverage, reimbursement, or salary reduction for 
less than twelve months, the plan is deemed not to operate to enable 
employees to purchase coverage only for periods when dependent care 
assistance will be received. See paragraph (a) in Sec.  1.125-2 and 
Sec.  1.125-4 regarding the revocation of elections during the period 
of coverage on account of changes in family status. See paragraph (e) 
in this section for required period of coverage for dependent care 
assistance.
    (iv) Examples. The following examples illustrate the rules in 
paragraphs (a)(4)(i)-(iii) of this section:

    Example 1. Initial non-refundable fee for child care. (i) 
Employer F maintains a calendar year cafeteria plan, offering 
employees an election between cash and qualified benefits, including 
dependent care assistance. Employee M has a one-year old dependent 
child. Employee M timely elected $5,000 of dependent care assistance 
for 2009. During the entire 2009 plan year, Employee M satisfies all 
the requirements in section 129 for dependent care assistance.
    (ii) On February 1, 2009, Employee M pays an initial non-
refundable fee of $500 to a licensed child care center (unrelated to 
Employer F or to Employee M), to reserve a space at the child care 
center for M's child. The child care center's monthly charges for 
child care are $1,200. When the child care center first begins to 
care for M's child, the $500 non-refundable fee is applied toward 
the first month's charges for child care.
    (iii) On March 1, 2009, the child care center begins caring for 
Employee M's child, and continues to care for the child through 
December 31, 2009. On March 1, 2009, M pays the child care center 
$700 (the balance of the $1,200 in charges for child care to be 
provided in March 2009). On April 1, 2009, M pays the child care 
center $1,200 for the child care to be provided in April 2009.

[[Page 43962]]

    (iv) Dependent care expenses are incurred when the services are 
provided. For dependent care services provided in March 2009, the 
$500 nonrefundable fee paid on February 1, 2009, and the $700 paid 
on March 1, 2009 may be reimbursed on or after the later of the date 
when substantiated or April 1, 2009. For dependent care services 
provided in April 2009, the $1,200 paid on April 1, 2009 may be 
reimbursed on or after the later of the date when substantiated or 
May 1, 2009.
    Example 2. Non-refundable fee forfeited. Same facts as Example 
1, except that the child care center never cared for M's child (who 
was instead cared for at Employer F's onsite child care facility). 
Because the child care center never provided child care services to 
Employee M's child, the $500 non-refundable fee is not reimbursable.

    (v) Optional spend-down provision. At the employer's option, the 
written cafeteria plan may provide that dependent care expenses 
incurred after the date an employee ceases participation in the 
cafeteria plan (for example, after termination) and through the last 
day of that plan year (or grace period immediately after that plan 
year) may be reimbursed from unused benefits, if all of the 
requirements of section 129 are satisfied.
    (vi) Example. The following example illustrates the rules in 
paragraph (a)(4)(v) of this section:

    Example. Terminated employee's post-termination dependent care 
expenses. (i) For calendar year 2009, Employee X elects $5,000 
salary reduction for dependent care assistance through Employer G's 
cafeteria plan. X works for Employer G from January 1 through June 
30, 2009, when X terminates employment. As of June 30, 2009, X had 
paid $2,500 in salary reduction and had incurred and was reimbursed 
for $2,000 of dependent care expenses.
    (ii) X does not work again until October 1, 2009, when X begins 
work for Employer H. X was employed by Employer H from October 1, 
2009 through December 31, 2009. During this period, X also incurred 
$500 of dependent care expenses. During all the periods of 
employment in 2009, X satisfied all requirements in section 129 for 
excluding payments for dependent care assistance from gross income.
    (iii) Employer G's cafeteria plan allows terminated employees to 
``spend down'' unused salary reduction amounts for dependent care 
assistance, if all requirements of section 129 are satisfied. After 
X's claim for $500 of dependent care expenses is substantiated, 
Employer G's cafeteria plan reimburses X for $500 (the remaining 
balance) of dependent care expenses incurred during X's employment 
for Employer H between October 1, 2009 and December 31, 2009. 
Employer G's cafeteria plan and operation are consistent with 
section 125.

    (b) Rules for claims substantiation for cafeteria plans--(1) 
Substantiation required before reimbursing expenses for qualified 
benefits. This paragraph (b) sets forth the substantiation requirements 
that a cafeteria plan must satisfy before paying or reimbursing any 
expense for a qualified benefit.
    (2) All claims must be substantiated. As a precondition of payment 
or reimbursement of expenses for qualified benefits, a cafeteria plan 
must require substantiation in accordance with this section. 
Substantiating only a percentage of claims, or substantiating only 
claims above a certain dollar amount, fails to comply with the 
substantiation requirements in Sec.  1.125-1 and this section.
    (3) Substantiation by independent third-party--(i) In general. All 
expenses must be substantiated by information from a third-party that 
is independent of the employee and the employee's spouse and 
dependents. The independent third-party must provide information 
describing the service or product, the date of the service or sale, and 
the amount. Self-substantiation or self-certification of an expense by 
an employee does not satisfy the substantiation requirements of this 
paragraph (b). The specific requirements in sections 105(b), 129, and 
137 must also be satisfied as a condition of reimbursing expenses for 
qualified benefits. For example, a health FSA does not satisfy the 
requirements of section 105(b) if it reimburses employees for expenses 
where the employees only submit information describing medical 
expenses, the amount of the expenses and the date of the expenses but 
fail to provide a statement from an independent third-party (either 
automatically or subsequent to the transaction) verifying the expenses. 
Under Sec.  1.105-2, all amounts paid under a plan that permits self-
substantiation or self-certification are includible in gross income, 
including amounts reimbursed for medical expenses, whether or not 
substantiated. See paragraph (m) in Sec.  1.125-5 for additional 
substantiation rules for limited-purpose and post-deductible health 
FSAs.
    (ii) Rules for substantiation of health FSA claims using an 
explanation of benefits provided by an insurance company--(A) Written 
statement from an independent third-party. If the employer is provided 
with information from an independent third-party (such as an 
``explanation of benefits'' (EOB) from an insurance company) indicating 
the date of the section 213(d) medical care and the employee's 
responsibility for payment for that medical care (that is, coinsurance 
payments and amounts below the plan's deductible), and the employee 
certifies that any expense paid through the health FSA has not been 
reimbursed and that the employee will not seek reimbursement from any 
other plan covering health benefits, the claim is fully substantiated 
without the need for submission of a receipt by the employee or further 
review.
    (B) Example. The following example illustrates the rules in this 
paragraph (b)(3):

    Example. Explanation of benefits. (i) During the plan year 
ending December 31, 2009, Employee Q is a participant in the health 
FSA sponsored by Employer J and is enrolled in Employer J's accident 
and health plan.
    (ii) On March 1, 2009, Q visits a physician's office for medical 
care as defined in section 213(d). The charge for the physician's 
services is $150. Under the plan, Q is responsible for 20 percent of 
the charge for the physician's services (that is, $30). Q has 
sufficient FSA coverage for the $30 claim.
    (iii) Employer J has coordinated with the accident and health 
plan so that Employer J or its agent automatically receives an EOB 
from the plan indicating that Q is responsible for payment of 20 
percent of the $150 charged by the physician. Because Employer J has 
received a statement from an independent third-party that Q has 
incurred a medical expense, the date the expense was incurred, and 
the amount of the expense, the claim is substantiated without the 
need for J to submit additional information regarding the expense. 
Employer J's FSA reimburses Q the $30 medical expense without 
requiring Q to submit a receipt or a statement from the physician. 
The substantiation rules in paragraph (b) in this section are 
satisfied.

    (4) Advance reimbursement of expenses for qualified benefits 
prohibited. Reimbursing expenses before the expense has been incurred 
or before the expense is substantiated fails to satisfy the 
substantiation requirements in Sec.  1.105-2, Sec.  1.125-1 and this 
section.
    (5) Purported loan from employer to employee. In determining 
whether, under all the facts and circumstances, employees are being 
reimbursed for unsubstantiated claims, special scrutiny will be given 
to other arrangements such as employer-to-employee loans based on 
actual or projected employee claims.
    (6) Debit cards. For purposes of this section, a debit card is a 
debit card, credit card, or stored value card. See also paragraphs (c) 
through (g) of this section for additional rules on payments or 
reimbursements made through debit cards.
    (c) Debit cards-overview--(1) Mandatory rules for all debit cards 
usable to pay or reimburse medical expenses. Paragraph (d) of this 
section sets forth the mandatory procedures for debit cards to 
substantiate section 213(d) medical expenses. These rules apply to all 
debit cards used to pay or

[[Page 43963]]

reimburse medical expenses. Paragraph (e) of this section sets forth 
additional substantiation rules that may be used for medical expenses 
incurred at medical care providers and certain stores with the Drug 
Stores and Pharmacies merchant category code. Paragraph (f) in this 
section sets forth the requirements for an inventory information 
approval system which must be used to substantiate medical expenses 
incurred at merchants or service providers that are not medical care 
providers or certain stores with the Drug Stores and Pharmacies 
merchant category code and that may be used for medical expenses 
incurred at all merchants.
    (2) Debit cards used for dependent care assistance. Paragraph (g) 
of this section sets forth additional rules for debit cards usable for 
reimbursing dependent care expenses.
    (3) Additional guidance. The Commissioner may prescribe additional 
guidance of general applicability, published in the Internal Revenue 
Bulletin (see Sec.  601.601(d)(2)(ii)(b) of this chapter), to provide 
additional rules for debit cards.
    (d) Mandatory rules for all debit cards usable to pay or reimburse 
medical expenses. A health FSA paying or reimbursing section 213(d) 
medical expenses through a debit card must satisfy all of the following 
requirements--
    (1) Before any employee participating in a health FSA receives the 
debit card, the employee agrees in writing that he or she will only use 
the card to pay for medical expenses (as defined in section 213(d)) of 
the employee or his or her spouse or dependents, that he or she will 
not use the debit card for any medical expense that has already been 
reimbursed, that he or she will not seek reimbursement under any other 
health plan for any expense paid for with a debit card, and that he or 
she will acquire and retain sufficient documentation (including 
invoices and receipts) for any expense paid with the debit card.
    (2) The debit card includes a statement providing that the 
agreements described in paragraph (d)(1) of this section are reaffirmed 
each time the employee uses the card.
    (3) The amount available through the debit card equals the amount 
elected by the employee for the health FSA for the cafeteria plan year, 
and is reduced by amounts paid or reimbursed for section 213(d) medical 
expenses incurred during the plan year.
    (4) The debit card is automatically cancelled when the employee 
ceases to participate in the health FSA.
    (5) The employer limits use of the debit card to--
    (i) Physicians, dentists, vision care offices, hospitals, other 
medical care providers (as identified by the merchant category code);
    (ii) Stores with the merchant category code for Drugstores and 
Pharmacies if, on a location by location basis, 90 percent of the 
store's gross receipts during the prior taxable year consisted of items 
which qualify as expenses for medical care described in section 213(d); 
and
    (iii) Stores that have implemented the inventory information 
approval system under paragraph (f).
    (6) The employer substantiates claims based on payments to medical 
care providers and stores described in paragraphs (d)(5)(i) and (ii) of 
this section in accordance with either paragraph (e) or paragraph (f) 
of this section.
    (7) The employer follows all of the following correction procedures 
for any improper payments using the debit card--
    (i) Until the amount of the improper payment is recovered, the 
debit card must be de-activated and the employee must request payments 
or reimbursements of medical expenses from the health FSA through other 
methods (for example, by submitting receipts or invoices from a 
merchant or service provider showing the employee incurred a section 
213(d) medical expense);
    (ii) The employer demands that the employee repay the cafeteria 
plan an amount equal to the improper payment;
    (iii) If, after the demand for repayment of improper payment (as 
described in paragraph (d)(7)(ii) of this section), the employee fails 
to repay the amount of the improper charge, the employer withholds the 
amount of the improper charge from the employee's pay or other 
compensation, to the full extent allowed by applicable law;
    (iv) If any portion of the improper payment remains outstanding 
after attempts to recover the amount (as described in paragraph 
(d)(7)(ii) and (iii) of this section), the employer applies a claims 
substitution or offset to resolve improper payments, such as a 
reimbursement for a later substantiated expense claim is reduced by the 
amount of the improper payment. So, for example, if an employee has 
received an improper payment of $200 and subsequently submits a 
substantiated claim for $250 incurred during the same coverage period, 
a reimbursement for $50 is made; and
    (v) If, after applying all the procedures described in paragraph 
(d)(7)(ii) through (iv) of this section, the employee remains indebted 
to the employer for improper payments, the employer, consistent with 
its business practice, treats the improper payment as it would any 
other business indebtedness.
    (e) Substantiation of expenses incurred at medical care providers 
and certain other stores with Drug Stores and Pharmacies merchant 
category code--(1) In general. A health FSA paying or reimbursing 
section 213(d) medical expenses through a debit card is permitted to 
comply with the substantiation provisions of this paragraph (e), 
instead of complying with the provisions of paragraph (f), for medical 
expenses incurred at providers described in paragraph (e)(2) of this 
section.
    (2) Medical care providers and certain other stores with Drug 
Stores and Pharmacies merchant category code. Medical expenses may be 
substantiated using the methods described in paragraph (e)(3) of this 
section if incurred at physicians, pharmacies, dentists, vision care 
offices, hospitals, other medical care providers (as identified by the 
merchant category code) and at stores with the Drug Stores and 
Pharmacies merchant category code, if, on a store location-by-location 
basis, 90 percent of the store's gross receipts during the prior 
taxable year consisted of items which qualify as expenses for medical 
care described in section 213(d).
    (3) Claims substantiation for copayment matches, certain recurring 
medical expenses and real-time substantiation. If all of the 
requirements in this paragraph (e)(3) are satisfied, copayment matches, 
certain recurring medical expenses and medical expenses substantiated 
in real-time are substantiated without the need for submission of 
receipts or further review.
    (i) Matching copayments--multiples of five or fewer. If an 
employer's accident or health plan covering the employee (or the 
employee's spouse or dependents) has copayments in specific dollar 
amounts, and the dollar amount of the transaction at a medical care 
provider equals an exact multiple of not more than five times the 
dollar amount of the copayment for the specific service (for example, 
pharmacy benefit copayment, copayment for a physician's office visit) 
under the accident or health plan covering the specific employee-
cardholder, then the charge is fully substantiated without the need for 
submission of a receipt or further review.
    (A) Tiered copayments. If a health plan has multiple copayments for 
the same benefit, (for example, tiered

[[Page 43964]]

copayments for a pharmacy benefit), exact matches of multiples or 
combinations of up to five copayments are similarly fully substantiated 
without the need for submission of a receipt or further review.
    (B) Copayment match must be exact multiple. If the dollar amount of 
the transaction is not an exact multiple of the copayment (or an exact 
match of a multiple or combination of different copayments for a 
benefit in the case of multiple copayments), the transaction must be 
treated as conditional pending confirmation of the charge, even if the 
amount is less than five times the copayment.
    (C) No match for multiple of six or more times copayment. If the 
dollar amount of the transaction at a medical care provider equals a 
multiple of six or more times the dollar amount of the copayment for 
the specific service, the transaction must be treated as conditional 
pending confirmation of the charge by the submission of additional 
third-party information. See paragraph (d) of this section. In the case 
of a plan with multiple copayments for the same benefit, if the dollar 
amount of the transaction exceeds five times the maximum copayment for 
the benefit, the transaction must also be treated as conditional 
pending confirmation of the charge by the submission of additional 
third-party information. In these cases, the employer must require that 
additional third-party information, such as merchant or service 
provider receipts, be submitted for review and substantiation, and the 
third-party information must satisfy the requirements in paragraph 
(b)(3) of this section.
    (D) Independent verification of copayment required. The copayment 
schedule required under the accident or health plan must be 
independently verified by the employer. Statements or other 
representations by the employee are not sufficient. Self-substantiation 
or self-certification of an employee's copayment in connection with 
copayment matching procedures through debit cards or otherwise does not 
constitute substantiation. If a plan's copayment matching system relies 
on an employee to provide a copayment amount without verification of 
the amount, claims have not been substantiated, and all amounts paid 
from the plan are included in gross income, including amounts paid for 
medical care whether or not substantiated. See paragraph (b) in this 
section.
    (4) Certain recurring medical expenses. Automatic payment or 
reimbursement satisfies the substantiation rules in this paragraph (e) 
for payment of recurring expenses that match expenses previously 
approved as to amount, medical care provider and time period (for 
example, for an employee who refills a prescription drug on a regular 
basis at the same provider and in the same amount). The payment is 
substantiated without the need for submission of a receipt or further 
review.
    (5) Real-time substantiation. If a third party that is independent 
of the employee and the employee's spouse and dependents (for example, 
medical care provider, merchant, or pharmacy benefit manager) provides, 
at the time and point of sale, information to verify to the employer 
(including electronically by email, the internet, intranet or 
telephone) that the charge is for a section 213(d) medical expense, the 
expense is substantiated without the need for further review.
    (6) Substantiation requirements for all other medical expenses paid 
or reimbursed through a health FSA debit card. All other charges to the 
debit card (other than substantiated copayments, recurring medical 
expenses or real-time substantiation, or charges substantiated through 
the inventory information approval system described in paragraph (f) of 
this section) must be treated as conditional, pending substantiation of 
the charge through additional independent third-party information 
describing the goods or services, the date of the service or sale and 
the amount of the transaction. All such debit card payments must be 
substantiated, regardless of the amount of the payment.
    (f) Inventory information approval system--(1) In general. An 
inventory information approval system that complies with this paragraph 
(f) may be used to substantiate payments made using a debit card, 
including payments at merchants and service providers that are not 
described in paragraph (e)(2) of this section. Debit card transactions 
using this system are fully substantiated without the need for 
submission of a receipt by the employee or further review.
    (2) Operation of inventory information approval system. An 
inventory information approval system must operate in the manner 
described in this paragraph (f)(2).
    (i) When an employee uses the card, the payment card processor's or 
participating merchant's system collects information about the items 
purchased using the inventory control information (for example, stock 
keeping units (SKUs)). The system compares the inventory control 
information for the items purchased against a list of items, the 
purchase of which qualifies as expenses for medical care under section 
213(d) (including nonprescription medications).
    (ii) The section 213(d) medical expenses are totaled and the 
merchant's or payment card processor's system approves the use of the 
card only for the amount of the section 213(d) medical expenses 
eligible for coverage under the health FSA (taking into consideration 
the uniform coverage rule in paragraph (d) of Sec.  1.125-5);
    (iii) If the transaction is only partially approved, the employee 
is required to tender additional amounts, resulting in a split-tender 
transaction. For example, if, after matching inventory information, it 
is determined that all items purchased are section 213(d) medical 
expenses, the entire transaction is approved, subject to the coverage 
limitations of the health FSA;
    (iv) If, after matching inventory information, it is determined 
that only some of the items purchased are section 213(d) medical 
expenses, the transaction is approved only as to the section 213(d) 
medical expenses. In this case, the merchant or service-provider must 
request additional payment from the employee for the items that do not 
satisfy the definition of medical care under section 213(d);
    (v) The merchant or service-provider must also request additional 
payment from the employee if the employee does not have sufficient 
health FSA coverage to purchase the section 213(d) medical items;
    (vi) Any attempt to use the card at non-participating merchants or 
service-providers must fail.
    (3) Employer's responsibility for ensuring inventory information 
approval system's compliance with Sec.  1.105-2, Sec.  1.125-1, Sec.  
1.125-6 and recordkeeping requirements. An employer that uses the 
inventory information approval system must ensure that the inventory 
information approval system complies with the requirements in 
Sec. Sec.  1.105-2, 1.125-1, and Sec.  1.125-6 for substantiating, 
paying or reimbursing section 213(d) medical expenses and with the 
recordkeeping requirements in section 6001.
    (g) Debit cards used to pay or reimburse dependent care 
assistance--(1) In general. An employer may use a debit card to provide 
benefits under its dependent care assistance program (including a 
dependent care assistance FSA). However, dependent care expenses may 
not be reimbursed before the expenses are incurred. See paragraph 
(a)(4) in this section. Thus, if a dependent care provider requires

[[Page 43965]]

payment before the dependent care services are provided, the expenses 
cannot be reimbursed at the time of payment through use of a debit card 
or otherwise.
    (2) Reimbursing dependent care assistance through a debit card. An 
employer offering a dependent care assistance FSA may adopt the 
following method to provide reimbursements for dependent care expenses 
through a debit card--
    (i) At the beginning of the plan year or upon enrollment in the 
dependent care assistance program, the employee pays initial expenses 
to the dependent care provider and substantiates the initial expenses 
by submitting to the employer or plan administrator a statement from 
the dependent care provider substantiating the dates and amounts for 
the services provided.
    (ii) After the employer or plan administrator receives the 
substantiation (but not before the date the services are provided as 
indicated by the statement provided by the dependent care provider), 
the plan makes available through the debit card an amount equal to the 
lesser of--
    (A) The previously incurred and substantiated expense; or
    (B) The employee's total salary reduction amount to date.
    (iii) The card may be used to pay for subsequently incurred 
dependent care expenses.
    (iv) The amount available through the card may be increased in the 
amount of any additional dependent care expenses only after the 
additional expenses have been incurred.
    (3) Substantiating recurring dependent care expenses. Card 
transactions that collect information matching expenses previously 
substantiated and approved as to dependent care provider and time 
period may be treated as substantiated without further review if the 
transaction is for an amount equal to or less than the previously 
substantiated expenses. Similarly, dependent care expenses previously 
substantiated and approved through nonelectronic methods may also be 
treated as substantiated without further review. In both cases, if 
there is an increase in previously substantiated amounts or a change in 
the dependent care provider, the employee must submit a statement or 
receipt from the dependent care provider substantiating the claimed 
expenses before amounts relating to the increased amounts or new 
providers may be added to the card.
    (4) Example. The following example illustrates the rules in this 
paragraph (g):

    Example. Recurring dependent care expenses. (i) Employer K 
sponsors a dependent care assistance FSA through its cafeteria plan. 
Salary reduction amounts for participating employees are made on a 
weekly payroll basis, which are available for dependent care 
coverage on a weekly basis. As a result, the amount of available 
dependent care coverage equals the employee's salary reduction 
amount minus claims previously paid from the plan. Employer K has 
adopted a payment card program for its dependent care FSA.
    (ii) For the plan year ending December 31, 2009, Employee F is a 
participant in the dependent care FSA and elected $5,000 of 
dependent care coverage. Employer K reduces F's salary by $96.15 on 
a weekly basis to pay for coverage under the dependent care FSA.
    (iii) At the beginning of the 2009 plan year, F is issued a 
debit card with a balance of zero. F's childcare provider, ABC 
Daycare Center, requires a $250 advance payment at the beginning of 
the week for dependent care services that will be provided during 
the week. The dependent care services provided for F by ABC qualify 
for reimbursement under section 129. However, because as of the 
beginning of the plan year, no services have yet been provided, F 
cannot be reimbursed for any of the amounts until the end of the 
first week of the plan year (that is, the week ending January 5, 
2009), after the services have been provided.
    (iv) F submits a claim for reimbursement that includes a 
statement from ABC with a description of the services, the amount of 
the services, and the dates of the services. Employer K increases 
the balance of F's payment card to $96.15 after the services have 
been provided (i.e., the lesser of F's salary reduction to date or 
the incurred dependent care expenses). F uses the card to pay ABC 
$96.15 on the first day of the next week (January 8, 2009) and pays 
ABC the remaining balance due for that week ($153.85) by check.
    (v) To the extent that this card transaction and each subsequent 
transaction is with ABC and is for an amount equal to or less than 
the previously substantiated amount, the charges are fully 
substantiated without the need for the submission by F of a 
statement from the provider or further review by the employer. 
However, the subsequent amount is not made available on the card 
until the end of the week when the services have been provided. 
Employer K's dependent care debit card satisfies the substantiation 
requirements of this paragraph (g).

    (h) Effective/applicability date. It is proposed that these 
regulations apply on and after plan years beginning on or after January 
1, 2009. However, the effective dates for the previously issued 
guidance on debit cards, which is incorporated in this section, remain 
applicable.


Sec.  1.125-7  Cafeteria plan nondiscrimination rules.

    (a) Definitions--(1) In general. The definitions set forth in this 
paragraph (a) apply for purposes of section 125(b), (c), (e) and (g) 
and this section.
    (2) Compensation. The term compensation means compensation as 
defined in section 415(c)(3).
    (3) Highly compensated individual. (i) In general. The term highly 
compensated individual means an individual who is--
    (A) An officer;
    (B) A five percent shareholder (as defined in paragraph (a)(8) of 
this section); or
    (C) Highly compensated.
    (ii) Spouse or dependent. A spouse or a dependent of any highly 
compensated individual described in (a)(3)(i) of this section is a 
highly compensated individual. Section 125(e).
    (4) Highly compensated participant. The term highly compensated 
participant means a highly compensated individual who is eligible to 
participate in the cafeteria plan.
    (5) Nonhighly compensated individual. The term nonhighly 
compensated individual means an individual who is not a highly 
compensated individual.
    (6) Nonhighly compensated participant. The term nonhighly 
compensated participant means a participant who is not a highly 
compensated participant.
    (7) Officer. The term officer means any individual or participant 
who for the preceding plan year (or the current plan year in the case 
of the first year of employment) was an officer. Whether an individual 
is an officer is determined based on all the facts and circumstances, 
including the source of the individual's authority, the term for which 
he or she is elected or appointed, and the nature and extent of his or 
her duties. Generally, the term officer means an administrative 
executive who is in regular and continued service. The term officer 
implies continuity of service and excludes individuals performing 
services in connection with a special and single transaction. An 
individual who merely has the title of an officer but not the authority 
of an officer, is not an officer. Similarly, an individual without the 
title of an officer but who has the authority of an officer is an 
officer. Sole proprietorships, partnerships, associations, trusts and 
labor organizations also may have officers. See Sec. Sec.  301.7701-1 
through -3
    (8) Five percent shareholder. A five percent shareholder is an 
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.

[[Page 43966]]

    (9) Highly compensated. The term highly compensated means any 
individual or participant who for the preceding plan year (or the 
current plan year in the case of the first year of employment) had 
compensation from the employer in excess of the compensation amount 
specified in section 414(q)(1)(B), and, if elected by the employer, was 
also in the top-paid group of employees (determined by reference to 
section 414(q)(3)) for such preceding plan year (or for the current 
plan year in the case of the first year of employment).
    (10) Key employee. A key employee is a participant who is a key 
employee within the meaning of section 416(i)(1) at any time during the 
preceding plan year. A key employee covered by a collective bargaining 
agreement is a key employee.
    (11) Collectively bargained plan. A collectively bargained plan is 
a plan or the portion of a plan maintained under an agreement which is 
a collective bargaining agreement between employee representatives and 
one or more employers, if there is evidence that cafeteria plan 
benefits were the subject of good faith bargaining between such 
employee representatives and such employer or employers.
    (12) Year of employment. For purposes of section 125(g)(3)(B)(i), a 
year of employment is determined by reference to the elapsed time 
method of crediting service. See Sec.  1.410(a)-7.
    (13) Premium-only-plan. A premium-only-plan is described in 
paragraph (a)(5) in Sec.  1.125-1.
    (14) Statutory nontaxable benefits. Statutory nontaxable benefits 
are qualified benefits that are excluded from gross income (for 
example, an employer-provided accident and health plan excludible under 
section 106 or a dependent care assistance program excludible under 
section 129). Statutory nontaxable benefits also include group-term 
life insurance on the life of an employee includible in the employee's 
gross income solely because the coverage exceeds the limit in section 
79(a).
    (15) Total benefits. Total benefits are qualified benefits and 
permitted taxable benefits.
    (b) Nondiscrimination as to eligibility--(1) In general. A 
cafeteria plan must not discriminate in favor of highly compensated 
individuals as to eligibility to participate for that plan year. A 
cafeteria plan does not discriminate in favor of highly compensated 
individuals if the plan benefits a group of employees who qualify under 
a reasonable classification established by the employer, as defined in 
Sec.  1.410(b)-4(b), and the group of employees included in the 
classification satisfies the safe harbor percentage test or the unsafe 
harbor percentage component of the facts and circumstances test in 
Sec.  1.410(b)-4(c). (In applying the Sec.  1.410(b)-4 test, substitute 
highly compensated individual for highly compensated employee and 
substitute nonhighly compensated individual for nonhighly compensated 
employee).
    (2) Deadline for participation in cafeteria plan. Any employee who 
has completed three years of employment (and who satisfies any 
conditions for participation in the cafeteria plan that are not related 
to completion of a requisite length of employment) must be permitted to 
elect to participate in the cafeteria plan no later than the first day 
of the first plan year beginning after the date the employee completed 
three years of employment (unless the employee separates from service 
before the first day of that plan year).
    (3) The safe harbor percentage test--(i) In general. For purposes 
of the safe harbor percentage test and the unsafe harbor percentage 
component of the facts and circumstances test, if the cafeteria plan 
provides that only employees who have completed three years of 
employment are permitted to participate in the plan, employees who have 
not completed three years of employment may be excluded from 
consideration. However, if the cafeteria plan provides that employees 
are allowed to participate before completing three years of employment, 
all employees with less than three years of employment must be included 
in applying the safe harbor percentage test and the unsafe harbor 
percentage component of the facts and circumstances test. See paragraph 
(g) of this section for a permissive disaggregation rule.
    (ii) Employees excluded from consideration. In addition, for 
purposes of the safe harbor percentage test and the unsafe harbor 
percentage component of the facts and circumstances test, the following 
employees are excluded from consideration--
    (A) Employees (except key employees) covered by a collectively 
bargained plan as defined in paragraph (a)(11) of this section;
    (B) Employees who are nonresident aliens and receive no earned 
income (within the meaning of section 911(d)(2)) from the employer 
which constitutes income from sources within the United States (within 
the meaning of section 861(a)(3)); and
    (C) Employees participating in the cafeteria plan under a COBRA 
continuation provision.
    (iv) Examples. The following examples illustrate the rules in 
paragraph (b) of this section:

    Example 1. Same qualified benefit for same salary reduction 
amount. Employer A has one employer-provided accident and health 
insurance plan. The cost to participants electing the accident and 
health plan is $10,000 per year for single coverage. All employees 
have the same opportunity to salary reduce $10,000 for accident and 
health plan. The cafeteria plan satisfies the eligibility test.
    Example 2. Same qualified benefit for unequal salary reduction 
amounts. Same facts as Example 1 except the cafeteria plan offers 
nonhighly compensated employees the election to salary reduce 
$10,000 to pay premiums for single coverage. The cafeteria plan 
provides an $8,000 employer flex-credit to highly compensated 
employees to pay a portion of the premium, and provides an election 
to them to salary reduce $2,000 to pay the balance of the premium. 
The cafeteria plan fails the eligibility test.
    Example 3. Accident and health plans of unequal value. Employer 
B's cafeteria plan offers two employer-provided accident and health 
insurance plans: Plan X, available only to highly compensated 
participants, is a low-deductible plan. Plan Y, available only to 
nonhighly compensated participants, is a high deductible plan (as 
defined in section 223(c)(2)). The annual premium for single 
coverage under Plan X is $15,000 per year, and $8,000 per year for 
Plan Y. Employer B's cafeteria plan provides that highly compensated 
participants may elect salary reduction of $15,000 for coverage 
under Plan X, and that nonhighly compensated participants may elect 
salary reduction of $8,000 for coverage under Plan Y. The cafeteria 
plan fails the eligibility test.
    Example 4. Accident and health plans of unequal value for 
unequal salary reduction amounts. Same facts as Example 3, except 
that the amount of salary reduction for highly compensated 
participants to elect Plan X is $8,000. The cafeteria plan fails the 
eligibility test.

    (c) Nondiscrimination as to contributions and benefits--(1) In 
general. A cafeteria plan must not discriminate in favor of highly 
compensated participants as to contributions and benefits for a plan 
year.
    (2) Benefit availability and benefit election. A cafeteria plan 
does not discriminate with respect to contributions and benefits if 
either qualified benefits and total benefits, or employer contributions 
allocable to statutory nontaxable benefits and employer contributions 
allocable to total benefits, do not discriminate in favor of highly 
compensated participants. A cafeteria plan must satisfy this paragraph 
(c) with respect to both benefit availability and benefit

[[Page 43967]]

utilization. Thus, a plan must give each similarly situated participant 
a uniform opportunity to elect qualified benefits, and the actual 
election of qualified benefits through the plan must not be 
disproportionate by highly compensated participants (while other 
participants elect permitted taxable benefits). Qualified benefits are 
disproportionately elected by highly compensated participants if the 
aggregate qualified benefits elected by highly compensated 
participants, measured as a percentage of the aggregate compensation of 
highly compensated participants, exceed the aggregate qualified 
benefits elected by nonhighly compensated participants measured as a 
percentage of the aggregate compensation of nonhighly compensated 
participants. A plan must also give each similarly situated participant 
a uniform election with respect to employer contributions, and the 
actual election with respect to employer contributions for qualified 
benefits through the plan must not be disproportionate by highly 
compensated participants (while other participants elect to receive 
employer contributions as permitted taxable benefits). Employer 
contributions are disproportionately utilized by highly compensated 
participants if the aggregate contributions utilized by highly 
compensated participants, measured as a percentage of the aggregate 
compensation of highly compensated participants, exceed the aggregate 
contributions utilized by nonhighly compensated participants measured 
as a percentage of the aggregate compensation of nonhighly compensated 
participants.
    (3) Example. The following example illustrates the rules in 
paragraph (c) of this section:

    Example. Contributions and benefits test. Employer C's cafeteria 
plan satisfies the eligibility test in paragraph (b) of this 
section. Highly compensated participants in the cafeteria plan elect 
aggregate qualified benefits equaling 5 percent of aggregate 
compensation; nonhighly compensated participants elect aggregate 
qualified benefits equaling 10 percent of aggregate compensation. 
Employer C's cafeteria plan passes the contribution and benefits 
test.

    (d) Key employees--(1) In general. If for any plan year, the 
statutory nontaxable benefits provided to key employees exceed 25 
percent of the aggregate of statutory nontaxable benefits provided for 
all employees through the cafeteria plan, each key employee includes in 
gross income an amount equaling the maximum taxable benefits that he or 
she could have elected for the plan year. However, see safe harbor for 
premium-only-plans in paragraph (f) of this section.
    (2) Example. The following example illustrates the rules in 
paragraph (d) of this section:

    Example. (i) Key employee concentration test. Employer D's 
cafeteria plan offers all employees an election between taxable 
benefits and qualified benefits. The cafeteria plan satisfies the 
eligibility test in paragraph (b) of this section. Employer D has 
two key employees and four nonhighly compensated employees. The key 
employees each elect $2,000 of qualified benefits. Each nonhighly 
compensated employee also elects $2,000 of qualified benefits. The 
qualified benefits are statutory nontaxable benefits.
    (ii) Key employees receive $4,000 of statutory nontaxable 
benefits and nonhighly compensated employees receive $8,000 of 
statutory nontaxable benefits, for a total of $12,000. Key employees 
receive 33 percent of statutory nontaxable benefits (4,000/12,000). 
Because the cafeteria plan provides more than 25 percent of the 
aggregate of statutory nontaxable benefits to key employees, the 
plan fails the key employee concentration test.

    (e) Safe harbor for cafeteria plans providing health benefits--(1) 
In general. A cafeteria plan that provides health benefits is not 
treated as discriminatory as to benefits and contributions if:
    (i) Contributions under the plan on behalf of each participant 
include an amount which equals 100 percent of the cost of the health 
benefit coverage under the plan of the majority of the highly 
compensated participants similarly situated, or equals or exceeds 75 
percent of the cost of the health benefit coverage of the participant 
(similarly situated) having the highest cost health benefit coverage 
under the plan, and
    (ii) Contributions or benefits under the plan in excess of those 
described in paragraph (e)(1)(i) of this section bear a uniform 
relationship to compensation.
    (2) Similarly situated. In determining which participants are 
similarly situated, reasonable differences in plan benefits may be 
taken into account (for example, variations in plan benefits offered to 
employees working in different geographical locations or to employees 
with family coverage versus employee-only coverage).
    (3) Health benefits. Health benefits for purposes of this rule are 
limited to major medical coverage and exclude dental coverage and 
health FSAs.
    (4) Example. The following example illustrates the rules in 
paragraph (e) of this section:

    Example. (i) All 10 of Employer E's employees are eligible to 
elect between permitted taxable benefits and salary reduction of 
$8,000 per plan year for self-only coverage in the major medical 
health plan provided by Employer E. All 10 employees elect $8,000 
salary reduction for the major medical plan.
    (ii) The cafeteria plan satisfies the section 125(g)(2) safe 
harbor for cafeteria plans providing health benefits.

    (f) Safe harbor test for premium-only-plans--(1) In general. A 
premium-only-plan (as defined in paragraph (a)(13) of this section) is 
deemed to satisfy the nondiscrimination rules in section 125(c) and 
this section for a plan year if, for that plan year, the plan satisfies 
the safe harbor percentage test for eligibility in paragraph (b)(3) of 
this section.
    (2) Example. The following example illustrates the rules in 
paragraph (f) of this section:

    Example. Premium-only-plan. (i) Employer F's cafeteria plan is a 
premium-only-plan (as defined in paragraph (a)(13) of this section). 
The written cafeteria plan offers one employer-provided accident and 
health plan and offers all employees the election to salary reduce 
same amount or same percentage of the premium for self-only or 
family coverage. All key employees and all highly compensated 
employees elect salary reduction for the accident and health plan, 
but only 20 percent of nonhighly compensated employees elect the 
accident and health plan.

    (ii) The premium-only-plan satisfies the nondiscrimination rules in 
section 125(b) and (c) and this section.
    (g) Permissive disaggregation for nondiscrimination testing--(1) 
General rule. If a cafeteria plan benefits employees who have not 
completed three years of employment, the cafeteria plan is permitted to 
test for nondiscrimination under this section as if the plan were two 
separate plans--
    (i) One plan benefiting the employees who completed one day of 
employment but less than three years of employment; and
    (ii) Another plan benefiting the employees who have completed three 
years of employment.
    (2) Disaggregated plans tested separately for eligibility test and 
contributions and benefits test. If a cafeteria plan is disaggregated 
into two separate plans for purposes of nondiscrimination testing, the 
two separate plans must be tested separately for both the 
nondiscrimination as to eligibility test in paragraph (b) of this 
section and the nondiscrimination as to contributions and benefits test 
in paragraph (c) of this section.
    (h) Optional aggregation of plans for nondiscrimination testing. An 
employer who sponsors more than one cafeteria plan is permitted to 
aggregate two or more of the cafeteria plans for purposes of 
nondiscrimination testing. If two or

[[Page 43968]]

more cafeteria plans are aggregated into a combined plan for this 
purpose, the combined plan must satisfy the nondiscrimination as to 
eligibility test in paragraph (b) of this section and the 
nondiscrimination as to contributions and benefits test in paragraph 
(c) of this section, as though the combined plan were a single plan. 
Thus, for example, in order to satisfy the benefit availability and 
benefit election requirements in paragraph (c)(2) of this section, the 
combined plan must give each similarly situated participant a uniform 
opportunity to elect qualified benefits and the actual election of 
qualified benefits by highly compensated participants must not be 
disproportionate. However, if a principal purpose of the aggregation is 
to manipulate the nondiscrimination testing requirements or to 
otherwise discriminate in favor of highly compensated individuals or 
participants, the plans will not be permitted to be aggregated for 
nondiscrimination testing.
    (i) Employees of certain controlled groups. All employees who are 
treated as employed by a single employer under section 414(b), (c), 
(m), or (o) are treated as employed by a single employer for purposes 
of section 125. Section 125(g)(4); section 414(t).
    (j) Time to perform nondiscrimination testing--(1) In general. 
Nondiscrimination testing must be performed as of the last day of the 
plan year, taking into account all non-excludable employees (or former 
employees) who were employees on any day during the plan year.
    (2) The following example illustrates the rules in paragraph (j) of 
this section:

    Example. When to perform discrimination testing. (i) Employer H 
employs three employees and maintains a calendar year cafeteria 
plan. During the 2009 plan year, Employee J was an employee the 
entire calendar year, Employee K was an employee from May 1, through 
August 31, 2009, and Employee L worked from January 1, 2009 to April 
15, 2009, when he retired.
    (ii) Nondiscrimination testing for the 2009 plan year must be 
performed on December 31, 2009, taking into account employees J, K, 
and L's compensation in the preceding year.

    (k) Discrimination in actual operation prohibited. In addition to 
not discriminating as to either benefit availability or benefit 
utilization, a cafeteria plan must not discriminate in favor of highly 
compensated participants in actual operation. For example, a plan may 
be discriminatory in actual operation if the duration of the plan (or 
of a particular nontaxable benefit offered through the plan) is for a 
period during which only highly compensated participants utilize the 
plan (or the benefit). See also the key employee concentration test in 
section 125(b)(2).
    (l) Anti-abuse rule--(1) Interpretation. The provisions of this 
section must be interpreted in a reasonable manner consistent with the 
purpose of preventing discrimination in favor of highly compensated 
individuals, highly compensated participants and key employees.
    (2) Change in plan testing procedures. A plan will not be treated 
as satisfying the requirements of this section if there are repeated 
changes to plan testing procedures or plan provisions that have the 
effect of manipulating the nondiscrimination testing requirements of 
this section, if a principal purpose of the changes was to achieve this 
result.
    (m) Tax treatment of benefits in a cafeteria plan--(1) 
Nondiscriminatory cafeteria plan. A participant in a nondiscriminatory 
cafeteria plan (including a highly compensated participant or key 
employee) who elects qualified benefits is not treated as having 
received taxable benefits offered through the plan, and thus the 
qualified benefits elected by the employee are not includible in the 
employee's gross income merely because of the availability of taxable 
benefits. But see paragraph (j) in Sec.  1.125-1 on nondiscrimination 
rules for sections 79(d), 105(h), 129(d), and 137(c)(2), and 
limitations on exclusion.
    (2) Discriminatory cafeteria plan. A highly compensated participant 
or key employee participating in a discriminatory cafeteria plan must 
include in gross income (in the participant's taxable year within which 
ends the plan year with respect to which an election was or could have 
been made) the value of the taxable benefit with the greatest value 
that the employee could have elected to receive, even if the employee 
elects to receive only the nontaxable benefits offered.
    (n) Employer contributions to employees' Health Savings Accounts. 
If an employer contributes to employees' Health Savings Accounts (HSAs) 
through a cafeteria plan (as defined in Sec.  54.4980G-5 of this 
chapter) those contributions are subject to the nondiscrimination rules 
in section 125 and this section and are not subject to the 
comparability rules in section 4980G. See Sec. Sec.  54.4980G-0 through 
54.4980G-5 of this chapter.
    (o) Effective/applicability date. It is proposed that these 
regulations apply on and after plan years beginning on or after January 
1, 2009.

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
 [FR Doc. E7-14827 Filed 8-3-07; 8:45 am]
BILLING CODE 4830-01-P