IRC 125 Cafeteria Plans
Tax Free Employee Benefit Plans
Patricia Huerta
ACB
TAX STRATEGIST
CELL949-627-6018
TEL 888-403-7211
AMERICAN GOLDEN BENEFITS
info@AmericanGoldenBenefits.com
AmericanGoldenBenefits.com

* * *

A section 125 plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable. A plan offering only a choice between taxable benefits is not a section 125 plan.

IRS REGS

Section 125 – Cafeteria Plans -- Modification of Application of Rule Prohibiting
Deferred Compensation Under a Cafeteria Plan
Part III - Administrative, Procedural, and Miscellaneous
Notice 2005-42
PURPOSE
The purpose of this notice is to modify the application of the rule
prohibiting deferred compensation under a § 125 cafeteria plan. This notice
permits a grace period immediately following the end of each plan year during
which unused benefits or contributions remaining at the end of the plan year may
be paid or reimbursed to plan participants for qualified benefit expenses incurred
during the grace period.
BACKGROUND
In general, no amount is included in the gross income of a participant in a
cafeteria plan solely because, under the plan, the participant may choose among
the benefits of the plan. Section 125(a). A cafeteria plan is defined in
§ 125(d)(1) as a written plan maintained by an employer under which all
participants are employees, and the participants may choose among two or more
benefits consisting of cash and qualified benefits. Section 125(f) defines a
“qualified benefit” as any benefit which, with the application of § 125(a), is not
includable in the gross income of the employee by reason of an express
provision of Chapter I of the Internal Revenue Code (other than §§ 106(b), 117,
127 or l32). Qualified benefits include employer-provided accident and health
plans excludable from gross income under §§ 106 and 105(b), group-term life
insurance excludable under § 79, dependent care assistance programs
excludable under § 129 and adoption assistance programs excludable under §
137. Elections under a cafeteria plan, once made, can be changed or revoked
only as provided in Treas. Reg. § 1.125-4. A cafeteria plan must have a plan
year specified in the written plan document. Prop. Treas. Reg. § 1.125-1, Q&A3.
 Section 125(d)(2)(A) states that the term “cafeteria plan”’ does not include
any plan which provides for deferred compensation. The statutory prohibition on
deferred compensation in a cafeteria plan is addressed in Prop. Treas. Reg. §§
1.125-1 and 1.125-2. Prop. Treas. Reg. § 1.125-2, Q&A-5 states that:
 A cafeteria plan may not include any plan that offers a benefit that defers
the receipt of compensation. In addition, a cafeteria plan may not operate
in a manner that enables employees to defer compensation. For example,
a plan that permits employees to carry over unused elective contributions
or plan benefits (e.g., accident or health plan coverage) from one plan
year to another operates to defer compensation. This is the case
2
regardless of how the contributions or benefits are used by the employee
in the subsequent plan year (e.g., 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 operates to permit the deferral of
compensation if the plan permits participants to use contributions for one
plan year to purchase a benefit that will be provided in a subsequent plan
year … .
See also Prop. Treas. Reg. § 1.125-1, Q&A-7.
 Thus, a cafeteria plan does not include any plan that defers the receipt of
compensation or operates in a manner that enables participants to defer
compensation by, for example, permitting participants to use contributions for
one plan year to purchase a benefit that will be provided in a subsequent plan
year. This rule is commonly referred to as the “use-it-or-lose-it” rule, requiring
that unused contributions or benefits remaining at the end of the plan year be
“forfeited.”
However, other areas of tax law provide that for a short, limited period,
compensation for services paid in the year following the year in which the
services that are being compensated were performed is not treated as “deferred
compensation.” For example, Treas. Reg. § 1.404(b)-1T, Q&A-2(a) provides that
for purposes of the deduction rules in § 404(a), (b) and (d), a plan, or method or
arrangement defers the receipt of compensation or benefits to the extent it is one
under which an employee receives compensation or benefits more than a brief
period of time after the end of the employer’s taxable year in which the services
creating the right to such compensation or benefits are performed. Under Treas.
Reg. § 1.404(b)-1T, Q&A-2(c), a plan, or method or arrangement shall not be
considered as deferring the receipt of compensation or benefits for more than a
brief period of time after the end of the employer’s taxable year to the extent that
compensation or benefits are received by the employee on or before the fifteenth
day of the third calendar month after the end of the employer’s taxable year in
which the services are rendered. See also Weaver v. Commissioner, 121 T.C.
273 (2003); Rev. Rul. 88-68, 1988-2 C.B. 117. Cf. H. R. Conf. Rep. No. 755,
108th Cong., 2d Sess. at 735 (2004) (§ 409A “does not apply to annual bonuses
or other annual compensation amounts paid within 2 and 1/2 months after the
close of the taxable year in which the relevant services required for payment
have been performed”). Consistent with these other areas of tax law, Treasury
and the IRS believe it is appropriate to modify the current prohibition on deferred
compensation in the proposed regulations under § 125 to permit a grace period
after the end of the plan year during which unused benefits or contributions may
be used.
3
MODIFICATION OF APPLICATION OF RULE PROHIBITING DEFERRED
COMPENSATION UNDER A § 125 CAFETERIA PLAN
The rule that a cafeteria plan may not defer the receipt of compensation
as set out in Prop. Treas. Reg. §§ 1.125-1 and 1.125-2 is modified as follows: A
cafeteria plan document may, at the employer’s option, be amended to provide
for a grace period immediately following the end of each plan year. The grace
period must apply to all participants in the cafeteria plan. Expenses for qualified
benefits incurred during the grace period may be paid or reimbursed from
benefits or contributions remaining unused at the end of the immediately
preceding plan year. The grace period must not extend beyond the fifteenth day
of the third calendar month after the end of the immediately preceding plan year
to which it relates (i.e., “the 2 and 1/2 month rule”). If a cafeteria plan document
is amended to include a grace period, a participant who has unused benefits or
contributions relating to a particular qualified benefit 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. The effect of the grace period is that the
participant may have as long as 14 months and 15 days (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 “useit-or-lose-it” rule.
During the grace period, a cafeteria plan may not permit unused benefits
or contributions to be cashed-out or converted to any other taxable or nontaxable
benefit. Unused benefits or contributions relating to a particular qualified benefit
may only be used to pay or reimburse expenses incurred with respect to that
particular qualified benefit. For example, unused amounts elected to pay or
reimburse medical expenses in a health flexible spending arrangement (FSA)
may not be used to pay or reimburse dependent care or other expenses incurred
during the grace period. 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) and are “forfeited” under the “use-it-or-lose-it” rule. As
under current practice, employers may continue to provide a “run-out” period
after the end of the grace period, during which expenses for qualified benefits
incurred during the cafeteria plan year and the grace period may be paid or
reimbursed.
An employer may adopt a grace period as authorized in this notice for the
current cafeteria plan year (and subsequent cafeteria plan years) by amending
the cafeteria plan document before the end of the current plan year.
 The rules of this notice are illustrated by the following examples:
4
 Example (1). Employer with a cafeteria plan year ending on December
31, 2005, amended the plan document before the end of the plan year to permit
a grace period which allows 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
adopted by the employer ends on the fifteenth day of the third calendar month
after the end of the plan year (March 15, 2006 for the plan year ending
December 31, 2005). Employee X timely elected salary reduction of $1,000 for a
health FSA for the plan year ending December 31, 2005. As of December 31,
2005, 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,
2006. During the grace period from January 1 through March 15, 2006, X incurs
$300 of unreimbursed medical expenses (as defined in § 213(d)). The unused
$200 from the plan year ending December 31, 2005 is applied to pay or
reimburse $200 of X’s $300 of medical expenses incurred during the grace
period. Therefore, as of March 16, 2006, X has no unused benefits or
contributions remaining for the plan year ending December 31, 2005. The
remaining $100 of medical expenses incurred between January 1 and March 15,
2006 is paid or reimbursed from X’s health FSA for the plan year ending
December 31, 2006. As of March 16, 2006, X has $1,400 remaining in the health
FSA for the plan year ending December 31, 2006.
Example (2). Same facts as Example (1), except that X incurs $150 of
§ 213(d) medical expenses during the grace period (January 1 through March
15, 2006). As of March 16, 2006, X has $50 of unused benefits or contributions
remaining for the plan year ending December 31, 2005. 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, 2006). The
unused $50 is subject to the “use-it-or-lose-it” rule and is “forfeited.” As of March
16, 2006, X has the entire $1,500 elected in the health FSA for the plan year
ending December 31, 2006.
EFFECT ON OTHER DOCUMENTS
Future guidance will modify Prop. Treas. Reg. §§ 1.125-1 and 1.125-2 to
reflect the provisions in this notice.
DRAFTING INFORMATION
The principal author of this notice is Elizabeth Purcell of the Office of
Division Counsel/Associate Chief Counsel (Tax Exempt and Government
Entities). For further information regarding this notice contact Ms. Purcell on
(202) 622-6080 (not a toll-free call).
 

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