Employers Must Amend Cafeteria Plans by Dec. 31 to Keep Up with Health Care Reform

08.16.10

By Jeff Belfiglio

Federal health care reform legislation both directly and indirectly impacts cafeteria plans. Recent Internal Revenue Service (IRS) guidance allows retroactive amendments to cafeteria plans consistent with health care reform during 2010. Additionally, employers must revise their cafeteria plans for changes taking effect during and after 2011. Employers need to be familiar with these changes now in order to communicate them during the next open enrollment period.

Mandatory changes

Effective for expenses incurred on or after Jan. 1, 2011, health flexible spending accounts (FSAs) in cafeteria plans may no longer reimburse for over-the-counter (OTC) drugs unless they are prescribed. The precise meaning of the terms “drugs” and “prescribed” is unclear, and we await further guidance from the IRS. The effective date is Jan. 1 even for noncalendar-year plans. (The same rule will apply to health reimbursement arrangements (HRAs) and health savings accounts (HSAs).) Thus, every cafeteria plan with a health FSA must be amended by Dec. 31, 2010, to exclude payment for OTC drugs, and this change must be communicated to plan participants so that they can adjust the amount they elect to contribute.

Plan sponsors may also want to take the opportunity to amend cafeteria plans at the same time to adopt the new $2,500 limit on health FSAs, which takes effect Jan. 1, 2013.

Election changes

Under health care reform, as of March 30, 2010, coverage of an employee’s child is tax-free through the end of the calendar year in which the child turns 26. Therefore, employers should no longer include the value of health coverage for such children in employees’ gross income. (Please see our earlier advisory, “Employers Can Stop Imputing Income to Employees on Health Coverage for Children under the Age of 27.”) Furthermore, because of this tax change, some health plans have made coverage for children through age 26 available in 2010, even though it is not mandatory until the first plan year beginning after Sept. 23, 2010.

Participants with covered “adult” children would want to change their cafeteria plan elections during 2010 to pay the premiums for such coverage on a pretax basis. Participants may also want to change their health FSA elections midyear because medical expenses of adult children are now reimbursable tax-free.

The IRS recognized two problems for cafeteria plans designed to allow such midyear changes for adult children. First, under the existing cafeteria plan regulations, they would not fit any of the limited “change of status” circumstances for which cafeteria plan election changes may be made outside the open enrollment period. Second, the regulations generally require cafeteria plans to be amended prospectively only.

But in Notice 2010-38 the IRS said that it would amend the change-of-election regulations to allow changes in elections for events affecting adult children’s eligibility, whether or not they are tax dependents. It will also allow amendments to cafeteria plans to allow such changes of election, retroactive to when the plan started allowing such changes in operation, if the amendment is adopted by Dec. 31, 2010.

Action items

Any cafeteria plan that has allowed changes of election with respect to adult children in 2010 must be amended by Dec. 31 to conform to its operation. Other cafeteria plans will still want to adopt the changes prospectively, before coverage of adult children becomes mandatory, effective the first plan year beginning after Sept. 23, 2010. And any cafeteria plan that has been reimbursing OTC drugs will have to be amended by Dec. 31, prospectively, to eliminate reimbursement unless the OTC drug is prescribed for an individual.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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