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1 [ u] DEPARTMENT OF THE TREASURY Internal Revenue Service 26 CFR Part 1 [TD 8921] RIN 1545-AY23 Tax Treatment of Cafeteria Plans AGENCY: Internal Revenue Service (IRS), Treasury. ACTION: Final regulations. SUMMARY: This document contains final regulations relating to section 125 cafeteria plans. The final regulations clarify the circumstances under which a cafeteria plan may permit an employee to change his or her cafeteria plan election with respect to accident or health coverage, group-term life insurance coverage, dependent care assistance and adoption assistance during the plan year. DATES: Effective Date: These regulations are effective January 10, Applicability Date: See the Scope of Regulations and Effective Date portion of this preamble. FOR FURTHER INFORMATION CONTACT: Christine L. Keller or Janet A. Laufer at (202) (not a toll-free number). 1
2 SUPPLEMENTARY INFORMATION: Background This document contains amendments to the Income Tax Regulations (26 CFR part 1) under section 125 of the Internal Revenue Code (Code). Section 125 generally provides that an employee in a cafeteria plan will not have an amount included in gross income solely because the employee may choose among two or more benefits consisting of cash and qualified benefits. A qualified benefit generally is any benefit that is excludable from gross income under an express provision of the Code, including coverage under an employer-provided accident or health plan under sections 105 and 106, group-term life insurance under section 79, elective contributions under a qualified cash or deferred arrangement within the meaning of section 401(k), dependent care 1 assistance under section 129, and adoption assistance under section 137. Qualified benefits can be provided under a cafeteria plan either through insured arrangements or arrangements that are not insured. 1 Section 125(f) provides that the following are not qualified benefits (even though they are generally excludable from gross income under an express provision of the Internal Revenue Code): products advertised, marketed, or offered as long-term care insurance; medical savings accounts under section 106(b); qualified scholarships under section 117; educational assistance programs under section 127; and fringe benefits under section
3 In 1984 and 1989, proposed regulations were published relating to cafeteria 2 plans. In general, the 1984 and 1989 proposed regulations require that, for benefits to be provided on a pre-tax basis under section 125, an employee may make changes during a plan year only in certain circumstances. Specifically, Q&A-8 of ' and Q&A-6(b), (c), and (d) of ' permit participants to make benefit election changes during a plan year pursuant to changes in cost or coverage, changes in family status, and separation from service. 3 In 2000, final regulations were issued permitting a participant in a cafeteria plan to change his or her accident or health coverage election during a period of coverage in specific circumstances such as where special enrollment rights arise under section 9801(f) (added to the Code by the Health Insurance Portability and Accountability Act of 1996 (HIPAA)(110 Stat. 1936), where eligibility for Medicare or Medicaid is gained or lost, or where a court issues a judgment, decree, or order requiring that an employee=s child or foster child who is a dependent receive health coverage. In addition, the final regulations permit an employee to change his or her accident or health coverage election or group-term life insurance election if certain change in status rules are satisfied. On the same day that the final regulations were issued, proposed regulations FR (May 7, 1984) and 54 FR 9460 (March 7, 1989), respectively. 3 TD 8878 at 65 FR (March 23, 2000). These final regulations were preceded by temporary regulations issued in See 62 FR (November 7, 1997) and 62 FR (November 7, 1997). 4 REG at 65 FR (March 23, 2000). 3
4 were also issued containing change in status rules that apply to other types of qualified benefits (i.e., dependent care assistance and adoption assistance) and describing the circumstances under which changes in the cost or coverage of qualified benefits provide a basis for changes in cafeteria plan elections. The IRS and Treasury received written comments on the proposed regulations and held a public hearing on August 17, Having considered the comments and the statements made at the hearing, the IRS and Treasury revise the final regulations and adopt the proposed regulations as modified by this Treasury decision. The comments and revisions are discussed below. Explanation of Provisions 1. Changes in the March 2000 Final Regulations With respect to group-term life insurance and disability coverage, the final regulations issued earlier this year provided flexibility by stating that, in the event of a change in an employee=s marital status or a change in the employment status of the employee=s spouse or dependent, an employee may elect either to increase such coverage or to decrease such coverage. 5 Commentators recommended that this rule also apply in the case of birth, adoption, placement for adoption, or death. The argument was made that in these other situations -- because these types of coverage are generally designed to provide income, instead of expense reimbursements -- it may 5 For example, an employee might seek to increase group-term life insurance due to a marriage (because of the need to provide income to the new spouse in the event that the chief wage-earner dies) or to decrease group-term life insurance due to a marriage (because the new spouse may be a wage-earner who can support the family in the event that the employee dies). 4
5 be appropriate for the employee to seek to increase or decrease the coverage. In accordance with these recommendations and in the interest of simplicity, the final regulations have been modified to allow participants to increase or decrease these types of coverage for all change of status events. Further, as also suggested by commentators, the final regulations have been modified to expand the rule to apply to coverage to which section 105(c) (which is coverage for permanent loss or loss of use of a member or function of the body) applies. Commentators requested clarification as to how the election change rules with respect to special enrollment rights under section 9801(f) (enacted under HIPAA) apply to a participant who marries if the group health plan allows the participant to change his or her health coverage election retroactively to the date of the marriage. In response to this comment, language has been added to an example in the final regulations to clarify that an election change can be funded through salary reduction under a cafeteria plan only on a prospective basis, except for the retroactive enrollment right under section 9801(f) that applies in the case of an election made within 30 days of a birth, adoption, or placement for adoption. With respect to accident or health coverage, the consistency rule in the final regulations requires that any employee who wishes to decrease or cancel coverage because he or she becomes eligible for coverage under a spouse=s or dependent=s plan due to a marital or employment change in status can do so only if he or she actually obtains coverage under that other plan. Commentators requested clarification as to the type of proof an employer must receive to satisfy this rule, expressing concern 5
6 that a plan could not implement a change on a timely basis because of a need to obtain proper proof of the other coverage. An example in the final regulations has been revised to make it clear that employers may generally rely on an employee=s certification that the employee has or will obtain coverage under the other plan (assuming that the employer has no reason to believe that the employee certification is incorrect ). The final regulations allow a participant to change his or her election if a judgment, decree or order resulting from a divorce, legal separation, annulment, or change in legal custody requires that an employee s spouse, former spouse, or other individual provide accident or health coverage for the employee s child or for a foster child who is a dependent of the employee. The final regulations were modified to clarify that the participant can only change his or her election if the spouse, former spouse, or other individual actually provides accident or health coverage for the child. 2. Changes From the March 2000 Proposed Regulations The final regulations being issued today are generally consistent with the proposed regulations that were issued earlier this year, but include various modifications. Cost and coverage rules The proposed regulations included rules allowing election changes in connection with a significant increase in cost or a significant curtailment in coverage, irrespective of whether the plan is insured or not insured. These cost and coverage rules (and the other rules in paragraph (f) of ' ) do not apply with respect to 6
7 6 coverage under a health FSA. However, all of the rules in paragraphs (a) through (e) and paragraph (g) of the final regulations under ' do apply with respect to coverage under a health FSA. One modification reflected in the final regulations is to clarify that the cost increase rules apply when the amount of an employee s elective contributions under section 125 increases either due to the employee contributing a larger portion of the total cost of the qualified benefits plan (which might occur, for example, if part-time employees pay a larger portion of a plan=s cost and the employee switches to part-time status) or due to an increase in the total cost of the qualified benefits plan. In response to comments, modifications were also made to allow election changes during a period of coverage when there is a significant decrease in the cost of a qualified benefits plan or in the cost of a benefits package option under the qualified benefits plan, as well as when there is a significant increase. Under the regulations as modified, if there is a significant decrease in the cost of a qualified benefits plan during the plan year, the final regulations permit a cafeteria plan to allow all employees, even those who have not previously participated in the cafeteria plan, to elect to participate in the qualified benefits plan through the cafeteria plan. Similarly, if there is a significant decrease in the cost of a benefits package option during the plan year, the final regulations permit a cafeteria plan to allow all eligible employees to elect that 6 A flexible spending arrangement (FSA) is defined in section 106(c)(2). Under section 106(c)(2), an FSA is generally a benefit program under which the maximum reimbursement reasonably available for coverage is less than 500% of the value of the coverage. A health FSA is an accident or health plan that is an FSA. 7
8 option (including employees who have elected another option, as well as those who have not previously participated in the cafeteria plan). Further, in response to comments, modifications were also made to allow midyear election changes when there is a significant improvement in the coverage provided under a benefit package option, as well as when there is a new benefit package option offered under the plan. Commentators also requested clarification as to whether a cafeteria plan could allow participants to drop coverage in response to a significant change in the cost or coverage of a qualified benefit. The final regulations clarify this issue, and provide that, if there is no other similar coverage, employees may drop coverage (including a change from family to single coverage) in response either to an increase in the cost of a qualified benefit or to a loss of coverage. The regulations also permit an employee to elect similar coverage in response to a significant curtailment in coverage. However, the regulations do not allow an employee to drop coverage altogether if there is a significant curtailment in coverage that does not constitute a loss of coverage. The regulations list the curtailments that are treated as a loss of coverage for this purpose, and include a complete loss of coverage (such as when an HMO ceases to be available in an area where an individual resides, or when an employee or a covered member of the employee=s family loses all coverage under a benefit package option by reason of a lifetime or annual limitation). In addition, the final regulations allow a cafeteria plan, in 8
9 7 its discretion, to treat certain other events as a loss of coverage. These events include a substantial decrease in medical care providers (such as a major hospital ceasing to be a member of a preferred provider network or a substantial decease in the physicians participating in a preferred provider network or an HMO), a reduction in the benefits for a specific type of medical condition or treatment with respect to which the employee or 8 the employee s spouse or dependent is currently in a course of treatment, or any other similar fundamental loss of coverage. For purposes of these rules, a significant curtailment occurs only if there is an overall reduction in coverage provided so as to constitute reduced coverage generally (i.e., a reduction in the fair market value of the coverage). Therefore, in most cases, the loss of one particular physician in a network does not constitute a significant curtailment. In response to comments, the rule under the proposed regulations that allowed an employee to change his or her election in response to a change made under a spouse=s or dependent=s plan has been clarified and broadened. Under the final regulations, the rule applies to coverage available from any employer plan, including any plan of the same employer and any plan of a different employer. In addition, the regulations have been modified to allow an employee to elect to participate in a 7 Such discretion may be exercised on a case by case basis, provided that the exercise of discretion satisfies section 125(c) which prohibits discrimination in favor of highly compensated participants. 8 Any reduction in coverage that affects a specific individual must not violate the prohibition in section 9802 against discrimination on the basis of health status (and parallel HIPAA provisions in the Employee Retirement Income Security Act of 1974 and the Public Health Service Act). See and T(b)(2). 9
10 cafeteria plan if the employee (or the employee=s spouse or dependent) loses coverage under a group health plan sponsored by a governmental or educational institution, such 9 as a state program under the State Children Health Insurance Program (SCHIP). The regulations do not allow a cafeteria plan participant to cease participation in a cafeteria plan if he or she becomes eligible for SCHIP coverage during the year because of a concern that such a rule would violate a fundamental principle of Title XXI of the Social Security Act that SCHIP coverage not supplant existing public or private coverage. Scope of Regulations and Effective Date These final regulations address all of the changes in status for which a cafeteria plan may permit election changes, including changes with respect to accident or health coverage, group-term life insurance, dependent care assistance and adoption assistance. In addition, the regulations contain guidance concerning election changes that are permitted because of changes in the cost or coverage of a qualified benefit plan. Unless specifically noted, these regulations do not override other cafeteria plan requirements such as the rules pertaining to health flexible spending arrangements, and the rules concerning the Family and Medical Leave Act (Public Law ( Stat. 6)). 9 Added to the Social Security Act by section 4901 of the Balanced Budget Act of 1997, Public Law (August 5, 1997). 10 See , published as a proposed rule at 60 FR (December 21, 1995). 10
11 The changes made by these regulations with respect to the March 2000 final regulations are applicable for cafeteria plan years beginning on or after January 1, 2001, except that the clarification made in paragraph (d)(1)(ii)(b) of these regulations (relating to a spouse, former spouse, or other individual obtaining accident or health coverage for an employee s child in response to a judgment, decree, or order) is applicable for cafeteria plan years beginning on or after January 1, With respect to the change made in paragraph (d)(1)(ii)(b) of these regulations, taxpayers may, until January 1, 2002, rely on either paragraph (d)(1)(ii)(b) of these regulations or the final regulations published in March 2000 (as (d)(1)(ii)). The changes made from the March 2000 proposed regulations (including the rules relating to cost or coverage in paragraph (f) of these regulations) are applicable for cafeteria plan years beginning on or after January 1, With respect to these changes (including the rules relating to cost or coverage in paragraph (f) of these regulations), taxpayers may, until January 1, 2002, rely on either these regulations, the proposed regulations published in March 2000 (under ), or the cost or coverage change rules in the 1989 proposed regulations (at (Q&A-6(b)). Special Analyses It has been determined that this Treasury decision is not a significant regulatory action as defined in Executive Order Therefore, a regulatory assessment is not required. It also has been determined that section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5) does not apply to these regulations, and because the regulation does not impose a collection of information on small entities, the 11
12 Regulatory Flexibility Act (5 U.S.C. chapter 6) does not apply. Pursuant to section 7805(f) of the Internal Revenue Code, these regulations will be submitted to the Chief Counsel for Advocacy of the Small Business Administration for comment on its impact on small business. Drafting Information The principal authors of these regulations are Christine L. Keller and Janet A. Laufer, Office of Division Counsel/ Associate Chief Counsel (Tax Exempt and Government Entities). However, other personnel from the IRS and Treasury Department participated in their development. List of Subjects in 26 CFR Part 1 Income taxes, Reporting and recordkeeping requirements. Adoption of Amendments to the Regulations Accordingly, 26 CFR part 1 is amended as follows: PART 1--INCOME TAXES Paragraph 1. The authority citation for part 1 continues to read in part as follows: Authority: 26 U.S.C * * * Par is amended by: 1. Revising paragraphs (b)(2) Example 2 (ii). 2. Revising paragraph (c)(1) and adding paragraph (c)(2)(vi). 3. Adding a sentence to the end of paragraph (c)(3)(i). 12
13 4. Removing the last sentence in paragraph (c)(3)(iii) and adding a sentence in its place. 5. Adding paragraph (c)(4) Example 3 (iii). 6. Revising paragraph (c)(4) Example 4 (ii) and adding paragraph (iii). 7. Adding paragraph (c)(4) Example 9 and (c)(4) Example Revising paragraph (d)(1)(ii). 9. Revising paragraphs (f), (g), (i)(3) and (i)(4). 10. Adding a sentence at the end of paragraph (i)(8), and adding paragraph (i)(9). 11. Revising paragraph (j). The additions and revisions read as follows: Permitted election changes. (a) Election changes. A cafeteria plan may permit an employee to revoke an election during a period of coverage and to make a new election only as provided in paragraphs (b) through (g) of this section. Section 125 does not require a cafeteria plan to permit any of these changes. See paragraph (h) of this section for special provisions relating to qualified cash or deferred arrangements, and paragraph (i) of this section for special definitions used in this section. (b) Special enrollment rights -- (1) In general. A cafeteria plan may permit an employee to revoke an election for coverage under a group health plan during a period of coverage and make a new election that corresponds with the special enrollment rights provided in section 9801(f). 13
14 (2) Examples. The following examples illustrate the application of this paragraph (b): Example 1. (i) Employer M provides health coverage for its employees pursuant to a plan that is subject to section 9801(f). Under the plan, employees may elect either employee-only coverage or family coverage. M also maintains a calendar year cafeteria plan under which qualified benefits, including health coverage, are funded through salary reduction. M s employee, A, is married to B and they have a child, C. In accordance with M=s cafeteria plan, Employee A elects employee-only health coverage before the beginning of the calendar year. During the year, A and B adopt a child, D. Within 30 days thereafter, A wants to revoke A s election for employee-only health coverage and obtain family health coverage for A=s spouse, C, and D as of the date of D s adoption. Employee A satisfies the conditions for special enrollment of an employee with a new dependent under section 9801(f)(2), so that A may enroll in family coverage under M s accident or health plan in order to provide coverage effective as of the date of D s adoption. (ii) M s cafeteria plan may permit A to change A=s salary reduction election to family coverage for salary not yet currently available. The increased salary reduction is permitted to reflect the cost of family coverage from the date of adoption. (A=s adoption of D is also a change in status, and the election of family coverage is consistent with that change in status. Thus, under paragraph (c) of this section, M=s cafeteria plan could permit A to elect family coverage prospectively in order to cover B, C, and D for the remaining portion of the period of coverage.) Example 2. (i) The employer plans and permissible coverage are the same as in Example 1. Before the beginning of the calendar year, Employee E elects employeeonly health coverage under M=s cafeteria plan. Employee E marries F during the plan year. F=s employer, N, offers health coverage to N=s employees, and, prior to the marriage, F had elected employee-only coverage. Employee E wants to revoke the election for employee-only coverage under M=s cafeteria plan, and is considering electing family health coverage under M=s plan or obtaining family health coverage under N=s plan. (ii) M=s cafeteria plan may permit E to change E=s salary reduction election to reflect the change to family coverage under M=s accident or health plan because the marriage would result in special enrollment rights under section 9801(f), pursuant to which an election of family coverage under M=s accident or health plan would be required to be effective no later than the first day of the first calendar month beginning after the completed request for enrollment is received by the plan. Since no retroactive coverage is required in the event of marriage under section 9801(f), E s salary reduction election may only be changed on a prospective basis. (E=s marriage to F is 14
15 also a change in status under paragraph (c) of this section, as illustrated in Example 1 of paragraph (c)(4) of this section.) (c) Changes in status -- (1) Change in status rule. A cafeteria plan may permit an employee to revoke an election during a period of coverage with respect to a qualified benefits plan (defined in paragraph (i)(8) of this section) to which this paragraph (c) applies and make a new election for the remaining portion of the period (referred to in this section as an election change) if, under the facts and circumstances - section. (i) A change in status described in paragraph (c)(2) of this section occurs; and (ii) The election change satisfies the consistency rule of paragraph (c)(3) of this (iii) Application to other qualified benefits. [Reserved] (2) Change in status events. The following events are changes in status for purposes of this paragraph (c): (i) Legal marital status. Events that change an employee s legal marital status, including the following: marriage; death of spouse; divorce; legal separation; and annulment. (ii) Number of dependents. Events that change an employee=s number of dependents, including the following: birth; death; adoption; and placement for adoption. (iii) Employment status. Any of the following events that change the employment status of the employee, the employee s spouse, or the employee s dependent: a termination or commencement of employment; a strike or lockout; a 15
16 commencement of or return from an unpaid leave of absence; and a change in worksite. In addition, if the eligibility conditions of the cafeteria plan or other employee benefit plan of the employer of the employee, spouse, or dependent depend on the employment status of that individual and there is a change in that individual=s employment status with the consequence that the individual becomes (or ceases to be) eligible under the plan, then that change constitutes a change in employment under this paragraph (c) (e.g., if a plan only applies to salaried employees and an employee switches from salaried to hourly-paid with the consequence that the employee ceases to be eligible for the plan, then that change constitutes a change in employment status under this paragraph (c)(2)(iii)). (iv) Dependent satisfies or ceases to satisfy eligibility requirements. Events that cause an employee=s dependent to satisfy or cease to satisfy eligibility requirements for coverage on account of attainment of age, student status, or any similar circumstance. (v) Residence. A change in the place of residence of the employee, spouse, or dependent. (vi) Adoption assistance. For purposes of adoption assistance provided through a cafeteria plan, the commencement or termination of an adoption proceeding. (3) Consistency rule -- (i) Application to accident or health coverage and groupterm life insurance. An election change satisfies the requirements of this paragraph (c)(3) with respect to accident or health coverage or group-term life insurance only if the election change is on account of and corresponds with a change in status that affects eligibility for coverage under an employer=s plan. A change in status that affects 16
17 eligibility under an employer s plan includes a change in status that results in an increase or decrease in the number of an employee s family members or dependents who may benefit from coverage under the plan. (ii) Application to other qualified benefits. [Reserved] (iii) Application of consistency rule. If the change in status is the employee=s divorce, annulment or legal separation from a spouse, the death of a spouse or dependent, or a dependent ceasing to satisfy the eligibility requirements for coverage, an employee=s election under the cafeteria plan to cancel accident or health insurance coverage for any individual other than the spouse involved in the divorce, annulment or legal separation, the deceased spouse or dependent, or the dependent that ceased to satisfy the eligibility requirements for coverage, respectively, fails to correspond with that change in status. Thus, if a dependent dies or ceases to satisfy the eligibility requirements for coverage, the employee=s election to cancel accident or health coverage for any other dependent, for the employee, or for the employee=s spouse fails to correspond with that change in status. In addition, if an employee, spouse, or dependent gains eligibility for coverage under a family member plan (as defined in paragraph (i)(5) of this section) as a result of a change in marital status under paragraph (c)(2)(i) of this section or a change in employment status under paragraph (c)(2)(iii) of this section, an employee=s election under the cafeteria plan to cease or decrease coverage for that individual under the cafeteria plan corresponds with that change in status only if coverage for that individual becomes applicable or is increased under the family member plan. With respect to group-term life insurance and disability 17
18 coverage (as defined in paragraph (i)(4) of this section), an election under a cafeteria plan to increase coverage (or an election to decrease coverage) in response to a change in status described in paragraph (c)(2) of this section is deemed to correspond with that change in status as required by paragraph (c)(3)(i) of this section. (iv) Exception for COBRA. If the employee, spouse, or dependent becomes eligible for continuation coverage under the group health plan of the employee=s employer as provided in section 4980B or any similar state law, a cafeteria plan may permit the employee to elect to increase payments under the employer=s cafeteria plan in order to pay for the continuation coverage. (4) The following examples illustrate the application of this paragraph (c): Example 1. (i) Employer M provides health coverage (including a health FSA) for its employees through its cafeteria plan. Before the beginning of the calendar year, Employee A elects employee-only health coverage under M s cafeteria plan and elects salary reduction contributions to fund coverage under the health FSA. Employee A marries B during the year. Employee B s employer, N, offers health coverage to N s employees (but not including any health FSA), and, prior to the marriage, B had elected employee-only coverage. Employee A wants to revoke the election for employee-only coverage, and is considering electing family health coverage under M s plan or obtaining family health coverage under N s plan. (ii) Employee A s marriage to B is a change in status under paragraph (c)(2)(i) of this section, pursuant to which B has become eligible for coverage under M=s health plan under paragraph (c)(3)(i) of this section. Two possible election changes by A correspond with the change in status: Employee A may elect family health coverage under M s plan to cover A and B; or A may cancel coverage under M s plan, if B elects family health coverage under N=s plan to cover A and B. Thus, M s cafeteria plan may permit A to make either election change. (iii) Employee A may also increase salary reduction contributions to fund coverage for B under the health FSA. 18
19 Example 2. (i) Employee C, a single parent, elects family health coverage under a calendar year cafeteria plan maintained by Employer O. Employee C and C s 21-year old child, D, are covered under O s health plan. During the year, D graduates from college. Under the terms of the health plan, dependents over the age of 19 must be full-time students to receive coverage. Employee C wants to revoke C s election for family health coverage and obtain employee-only coverage under O s cafeteria plan. (ii) D s loss of eligibility for coverage under the terms of the health plan is a change in status under paragraph (c)(2)(iv) of this section. A revocation of C=s election for family coverage and new election for employee-only coverage corresponds with the change in status. Thus, O s cafeteria plan may permit C to elect employee-only coverage. Example 3. (i) Employee E is married to F and they have one child, G. Employee E is employed by Employer P, and P maintains a calendar year cafeteria plan that allows employees to elect no health coverage, employee-only coverage, employee-plus-one-dependent coverage, or family coverage. Under the plan, before the beginning of the calendar year, E elects family health coverage for E, F, and G. E and F divorce during the year and F loses eligibility for coverage under P=s plan. G does not lose eligibility for health coverage under P=s plan upon the divorce. E now wants to revoke E=s election under the cafeteria plan and elect no coverage. (ii) The divorce is a change in status under paragraph (c)(2)(i). A change in the cafeteria plan election to cancel health coverage for F is consistent with that change in status. However, an election change to cancel E=s or G=s health coverage does not satisfy the consistency rule under paragraph (c)(3)(iii) of this section regarding cancellation of coverage for an employee=s other dependents in the event of divorce. Therefore, the cafeteria plan may not permit E to elect no coverage. However, an election to change to employee-plus-one-dependent health coverage would correspond with the change in status, and thus the cafeteria plan may permit E to elect employee-plus-one-dependent health coverage. (iii) In addition, under paragraph (f)(4) of this section, if F makes an election change to cover G under F s employer s plan, then E may make a corresponding change to elect employee-only coverage under P s cafeteria plan. Example 4. (i) Employer R maintains a calendar year cafeteria plan under which full-time employees may elect coverage under one of three benefit package options provided under an accident or health plan: an indemnity option or either of two HMO options for employees who work in the respective service areas of the two HMOs. Employee A, who works in the service area of HMO #1, elects the HMO #1 option. During the year, A is transferred to another work location which is outside the HMO #1 service area and inside the HMO #2 service area. 19
20 (ii) The transfer is a change in status under paragraph (c)(2)(iii) of this section (relating to a change in worksite), and, under the consistency rule in paragraph (c)(3) of this section, the cafeteria plan may permit A to make an election change to elect the indemnity option or HMO #2 or to cancel accident or health coverage. (iii) The change in work location has no effect on A s eligibility under R s health FSA, so no change in A s health FSA is authorized under this paragraph (c). Example 5. (i) Employer S maintains a calendar year cafeteria plan that allows employees to elect coverage under an accident or health plan providing indemnity coverage and coverage under a health FSA. Prior to the beginning of the calendar year, Employee B elects employee-only indemnity coverage, and elects salary reduction contributions of $600 during the year to fund coverage under the health FSA for up to $600 of reimbursements for the year. Employee B's spouse, C, has employee-only coverage under an accident or health plan maintained by C's employer. During the year, C terminates employment and loses coverage under that plan. B now wants to elect family coverage under S's accident or health plan and increase B's FSA election. (ii) C's termination of employment is a change in status under paragraph (c)(2)(iii) of this section, and the election change satisfies the consistency rule of paragraph (c)(3) of this section. Therefore, the cafeteria plan may permit B to elect family coverage under S's accident or health plan and to increase B's FSA coverage. Example 6. (i) Employer T provides group-term life insurance coverage as described under section 79. Under T's plan, an employee may elect life insurance coverage in an amount up to $50,000. T also maintains a calendar year cafeteria plan under which qualified benefits, including the group-term life insurance coverage, are funded through salary reduction. Employee D has a spouse and a child. Before the beginning of the year, D elects $10,000 of group-term life insurance coverage. During the year, D is divorced. (ii) The divorce is a change in status under paragraph (c)(2)(i) of this section. Under paragraph (c)(3)(iii) of this section, either an increase or a decrease in coverage is consistent with this change in status. Thus, T's cafeteria plan may permit D to increase or to decrease D's group-term life insurance coverage. Example 7. (i) Employee E is married to F and they have one child, G. Employee E=s employer, U, maintains a cafeteria plan under which employees may elect no coverage, employee-only coverage, or family coverage under a group health plan maintained by U, and may make a separate vision coverage election under the plan. Before the beginning of the calendar year, E elects family health coverage and no vision coverage under U=s cafeteria plan. Employee F=s employer, V, maintains a cafeteria 20
21 plan under which employees may elect no coverage, employee-only coverage, or family coverage under a group health plan maintained by V, and may make a separate vision coverage election under the plan. Before the beginning of the calendar year, F elects no health coverage and employee-only vision coverage under V=s plan. During the year, F terminates employment with V and loses vision coverage under V=s plan. Employee E now wants to elect family vision coverage under U=s group health plan. (ii) F=s termination of employment is a change in status under paragraph (c)(2)(iii) of this section, and the election change satisfies the consistency rule of paragraph (c)(3) of this section. Therefore, U=s cafeteria plan may permit E to elect family vision coverage (covering E and G as well as F) under U=s group health plan. Example 8. (i) Before the beginning of the year, Employee H elects to participate in a cafeteria plan maintained by H s employer, W. However, in order to change the election during the year so as to cancel coverage, and by prior understanding with W, H terminates employment and resumes employment one week later. (ii) In this Example 8, under the facts and circumstances, a principal purpose of the termination of employment was to alter the election, and reinstatement of employment was understood at the time of termination. Accordingly, H does not have a change in status under paragraph (c)(2)(iii) of this section. (iii) However, H s termination of employment would constitute a change in status, permitting a cancellation of coverage during the period of unemployment, if H s original cafeteria plan election for the period of coverage was reinstated upon resumption of employment (for example, if W=s cafeteria plan contains a provision requiring an employee who resumes employment within 30 days, without any other intervening event that would permit a change in election, to return to the election in effect prior to termination of employment). (iv) If, instead, H terminates employment and cancels coverage during a period of unemployment, and then returns to work more than 30 days following termination of employment, the cafeteria plan may permit H the option of returning to the election in effect prior to termination of employment or making a new election under the plan. Alternatively, the cafeteria plan may prohibit H from returning to the plan during that plan year. Example 9. (i) Employee A has one child, B. Employee A s employer, X, maintains a calendar year cafeteria plan that allows employees to elect coverage under a dependent care FSA. Prior to the beginning of the calendar year, A elects salary reduction contributions of $4,000 during the year to fund coverage under the dependent 21
22 care FSA for up to $4,000 of reimbursements for the year. During the year, B reaches the age of 13, and A wants to cancel coverage under the dependent care FSA. (ii) When B turns 13, B ceases to satisfy the definition of qualifying individual under section 21(b)(1) of the Internal Revenue Code. Accordingly, B s attainment of age 13 is a change in status under paragraph (c)(2)(iv) of this section that affects A s employment-related expenses as defined in section 21(b)(2). Therefore, A may make a corresponding change under X s cafeteria plan to cancel coverage under the dependent care FSA. Example 10. (i) Employer Y maintains a calendar year cafeteria plan under which full-time employees may elect coverage under either an indemnity option or an HMO. Employee C elects the employee-only indemnity option. During the year, C marries D. D has two children from a previous marriage, and has family group health coverage in a cafeteria plan sponsored by D s employer, Z. C wishes to change from employee-only indemnity coverage to HMO coverage for the family. D wishes to cease coverage in Z s group health plan and certifies to Z that D will have family coverage under C s plan (and Z has no reason to believe the certification is incorrect). (ii) The marriage is a change in status under paragraph (c)(2)(i) of this section. Under the consistency rule in paragraph (c)(3) of this section, Y s cafeteria plan may permit C to change his or her salary reduction contributions to reflect the change from employee-only indemnity to HMO family coverage, and Z may permit D to revoke coverage under Z s cafeteria plan. (d) Judgment, decree, or order -- (1) Conforming election change. This paragraph (d) applies to a judgment, decree, or order (order) resulting from a divorce, legal separation, annulment, or change in legal custody (including a qualified medical child support order as defined in section 609 of the Employee Retirement Income Security Act of 1974 (Public Law (88 Stat. 829))) that requires accident or health coverage for an employee's child or for a foster child who is a dependent of the employee. A cafeteria plan will not fail to satisfy section 125 if it -- (i) Changes the employee's election to provide coverage for the child if the order requires coverage for the child under the employee's plan; or 22
23 (ii) Permits the employee to make an election change to cancel coverage for the child if: (A) The order requires the spouse, former spouse, or other individual to provide coverage for the child; and (B) That coverage is, in fact, provided. (2) Example. The following example illustrates the application of this paragraph (d): Example. (i) Employer M maintains a calendar year cafeteria plan that allows employees to elect no health coverage, employee-only coverage, employee-plus-onedependent coverage, or family coverage. M=s employee, A, is married to B and they have one child, C. Before the beginning of the year, A elects employee-only health coverage. Employee A divorces B during the year and, pursuant to A s divorce agreement with B, M s health plan receives a qualified medical child support order (as defined in section 609 of the Employee Retirement Income Security Act of 1974) during the plan year. The order requires M s health plan to cover C. (ii) Under this paragraph (d), M s cafeteria plan may change A s election from employee-only health coverage to employee-plus-one-dependent coverage in order to cover C. (e) Entitlement to Medicare or Medicaid. If an employee, spouse, or dependent who is enrolled in an accident or health plan of the employer becomes entitled to coverage (i.e., becomes enrolled) under Part A or Part B of Title XVIII of the Social Security Act (Medicare)(Public Law (79 Stat. 291)) or Title XIX of the Social 23
24 Security Act (Medicaid)(Public Law (79 Stat. 343)), other than coverage consisting solely of benefits under section 1928 of the Social Security Act (the program for distribution of pediatric vaccines), a cafeteria plan may permit the employee to make a prospective election change to cancel or reduce coverage of that employee, spouse, or dependent under the accident or health plan. In addition, if an employee, spouse, or dependent who has been entitled to such coverage under Medicare or Medicaid loses eligibility for such coverage, the cafeteria plan may permit the employee to make a prospective election to commence or increase coverage of that employee, spouse, or dependent under the accident or health plan. (f) Significant cost or coverage changes -- (1) In general. Paragraphs (f)(2) through (5) of this section set forth rules for election changes as a result of changes in cost or coverage. This paragraph (f) does not apply to an election change with respect to a health FSA (or on account of a change in cost or coverage under a health FSA). (2) Cost changes - - (i) Automatic changes. If the cost of a qualified benefits plan increases (or decreases) during a period of coverage and, under the terms of the plan, employees are required to make a corresponding change in their payments, the cafeteria plan may, on a reasonable and consistent basis, automatically make a prospective increase (or decrease) in affected employees= elective contributions for the plan. (ii) Significant cost changes. If the cost charged to an employee for a benefit package option (as defined in paragraph (i)(2) of this section) significantly increases or significantly decreases during a period of coverage, the cafeteria plan may permit the 24
25 employee to make a corresponding change in election under the cafeteria plan. Changes that may be made include commencing participation in the cafeteria plan for the option with a decrease in cost, or, in the case of an increase in cost, revoking an election for that coverage and, in lieu thereof, either receiving on a prospective basis coverage under another benefit package option providing similar coverage or dropping coverage if no other benefit package option providing similar coverage is available. For example, if the cost of an indemnity option under an accident or health plan significantly increases during a period of coverage, employees who are covered by the indemnity option may make a corresponding prospective increase in their payments or may instead elect to revoke their election for the indemnity option and, in lieu thereof, elect coverage under another benefit package option including an HMO option (or drop coverage under the accident or health plan if no other benefit package option is offered). (iii) Application of cost changes. For purposes of paragraphs (f)(2)(i) and (ii) of this section, a cost increase or decrease refers to an increase or decrease in the amount of the elective contributions under the cafeteria plan, whether that increase or decrease results from an action taken by the employee (such as switching between fulltime and part-time status) or from an action taken by an employer (such as reducing the amount of employer contributions for a class of employees). (iv) Application to dependent care. This paragraph (f)(2) applies in the case of a dependent care assistance plan only if the cost change is imposed by a dependent care provider who is not a relative of the employee. For this purpose, a relative is an 25
26 individual who is related as described in section 152(a)(1) through (8), incorporating the rules of section 152(b)(1) and (2). (3) Coverage changes - - (i) Significant curtailment without loss of coverage. If an employee (or an employee s spouse or dependent) has a significant curtailment of coverage under a plan during a period of coverage that is not a loss of coverage as described in paragraph (f)(3)(ii) of this section (for example, there is a significant increase in the deductible, the copay, or the out-of-pocket cost sharing limit under an accident or health plan), the cafeteria plan may permit any employee who had been participating in the plan and receiving that coverage to revoke his or her election for that coverage and, in lieu thereof, to elect to receive on a prospective basis coverage under another benefit package option providing similar coverage. Coverage under a plan is significantly curtailed only if there is an overall reduction in coverage provided under the plan so as to constitute reduced coverage generally. Thus, in most cases, the loss of one particular physician in a network does not constitute a significant curtailment. (ii) Significant curtailment with loss of coverage. If an employee (or the employee s spouse or dependent) has a significant curtailment that is a loss of coverage, the plan may permit that employee to revoke his or her election under the cafeteria plan and, in lieu thereof, to elect either to receive on a prospective basis coverage under another benefit package option providing similar coverage or to drop coverage if no similar benefit package option is available. For purposes of this paragraph (f)(3)(ii), a loss of coverage means a complete loss of coverage under the benefit package option or other coverage option (including the elimination of a benefits 26
27 package option, an HMO ceasing to be available in the area where the individual resides, or the individual losing all coverage under the option by reason of an overall lifetime or annual limitation). In addition, the cafeteria plan may, in its discretion, treat the following as a loss of coverage - - (A) A substantial decrease in the medical care providers available under the option (such as a major hospital ceasing to be a member of a preferred provider network or a substantial decrease in the physicians participating in a preferred provider network or an HMO); (B) A reduction in the benefits for a specific type of medical condition or treatment with respect to which the employee or the employee=s spouse or dependent is currently in a course of treatment; or (C) Any other similar fundamental loss of coverage. (iii) Addition or improvement of a benefit package option. If a plan adds a new benefit package option or other coverage option, or if coverage under an existing benefit package option or other coverage option is significantly improved during a period of coverage, the cafeteria plan may permit eligible employees (whether or not they have previously made an election under the cafeteria plan or have previously elected the benefit package option) to revoke their election under the cafeteria plan and, in lieu thereof, to make an election on a prospective basis for coverage under the new or improved benefit package option. (4) Change in coverage under another employer plan. A cafeteria plan may permit an employee to make a prospective election change that is on account of and 27
28 corresponds with a change made under another employer plan (including a plan of the same employer or of another employer) if - - (i) The other cafeteria plan or qualified benefits plan permits participants to make an election change that would be permitted under paragraphs (b) through (g) of this section (disregarding this paragraph (f)(4)); or (ii) The cafeteria plan permits participants to make an election for a period of coverage that is different from the period of coverage under the other cafeteria plan or qualified benefits plan. (5) Loss of coverage under other group health coverage. A cafeteria plan may permit an employee to make an election on a prospective basis to add coverage under a cafeteria plan for the employee, spouse, or dependent if the employee, spouse, or dependent loses coverage under any group health coverage sponsored by a governmental or educational institution, including the following - - (i) A State s children s health insurance program (SCHIP) under Title XXI of the Social Security Act; (ii) A medical care program of an Indian Tribal government (as defined in section 7701(a)(40)), the Indian Health Service, or a tribal organization (iii) A State health benefits risk pool; or (iv) A Foreign government group health plan. (6) Examples. The following examples illustrate the application of this paragraph (f): 28
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