IRS Revenue Ruling
2002-27

 
Code Secs. 125, 106

<<FULL TEXT>>

(Also section 106, section 415.)

Cafeteria plans. Cafeteria plans may use an automatic enrollment
process whereby the employee's salary is reduced each year to pay for a
portion of the group health coverage under the plan unless the employee
affirmatively elects cash. In addition, employers may treat all
participants as being in the cafeteria plan for section 415 purposes even
though the plan mandates salary reduction and coverage for uninsured
participants.


REV. RUL. 2002-27

ISSUES

(1) Whether employer contributions used to purchase group health
coverage under section 125 of the Internal Revenue Code are included in
the gross income of the employee solely because the plan uses an automatic
enrollment process whereby the employee's salary is reduced each year to
pay for a portion of the coverage unless the employee affirmatively elects
to receive the amount in cash.

(2) Whether an employer can treat contributions used to purchase group
health coverage as compensation for purposes of section 415(c)(3) when the
employee does not have the opportunity to elect cash in lieu of such
contributions under a section 125 arrangement because the employee is not
able to certify that he or she has other health coverage.


FACTS

Situation (1). Employer M maintains a calendar year cafeteria plan
("Plan"). The Plan offers group health insurance indemnity coverage with
the option for employee-only or family coverage. The Plan is in writing
and is available to all employees immediately upon hire.

The Plan provides for an automatic enrollment process. Under this Plan
feature, each new employee (and each current employee for the first plan
year the automatic enrollment process is effective) is automatically
enrolled in employee-only indemnity coverage, with the employee's salary
reduced pre-tax to pay for a portion of the cost of the coverage, unless
the employee affirmatively elects cash. Alternatively, if the employee has
a spouse or child, he or she can elect family coverage.

At the time 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 will be 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.

For a new hire, an election to receive cash or to have family coverage
rather than employee-only coverage is effective if made when the employee
is hired or within a reasonable period ending before the compensation for
the first pay period is currently available. 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 section 1.125-4 of the
Income Tax Regulations. An election made for any prior year carries over
to the next succeeding plan year unless changed.

Situation (2). Employer N also maintains a plan ("Plan") that offers
group health insurance indemnity coverage which includes employee-only and
family coverage options and has an automatic enrollment process. The
automatic enrollment process is the same as that described in Situation
(1), except that, under N's automatic enrollment process a new employee
(and each current employee for the first calendar plan year the automatic
enrollment process is effective) can affirmatively elect to receive cash,
either at hire or during the annual election period under the Plan, only
if the employee certifies that he or she has other health coverage.
Employer N does not otherwise request or collect from employees
information regarding other health coverage as part of the enrollment
process. The Plan procedures relating to notice to employees and elections
under this Plan are otherwise the same as those under the Plan sponsored
by Employer M.


LAW AND ANALYSIS

SECTIONS 106 AND 125

In general, section 106(a) provides that gross income of an employee
does not include employer-provided coverage under an accident or health
plan.

Section 125(a) states that no amount will be 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(d) defines a cafeteria plan as a written plan 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 qualified benefits as any benefit not includible
in the gross income of the employee by reason of an express provision of
Chapter 1 of the Code other than certain specified benefits that are not
qualified benefits. Qualified benefits include employer-provided accident
or health coverage under section 106(a).

Section 125 applies if the employee can choose between cash and
qualified benefits. However, section 125 permits an employee's choice to
be either in the form of an affirmative election to receive qualified
benefits in lieu of cash or an affirmative election to receive cash in
lieu of qualified benefits. Under Employer M's automatic enrollment
process as described in Situation (1), an employee's salary is reduced
pursuant to a procedure under which the employee receives a notice
explaining his or her right to have group health coverage through salary
reduction or to decline such coverage and receive the cash instead. After
receiving the notice, the employee has an opportunity to choose between
cash and a qualified benefit. Therefore, the Plan's automatic enrollment
process is subject to the requirements of section 125.

The same conclusions apply to Situation (2) to the extent that an
employee can elect cash. However, under Employer N's automatic enrollment
process as described in Situation (2), an employee who does not have other
health coverage is not given a choice between cash and a qualified benefit
with respect to the employee-only option under the indemnity coverage.
Rather, if the employee cannot certify that he or she has other health
coverage, the pre-tax salary reduction is mandatory and the employee is
automatically enrolled in the employee-only indemnity coverage. With
respect to these employees, because there is no ability to elect cash
instead of employee-only coverage, section 125 is not applicable to the
employee-only coverage. (Section 125 is applicable, however, to these
employees' elections to take family coverage instead of employee-only
coverage).


SECTION 415

Section 415 imposes limitations on contributions and benefits under
qualified retirement plans. Some of the limitations under section 415 that
may apply to contributions or benefits provided on behalf of a participant
are based on the participant's compensation, within the meaning of section
415(c)(3). The definition of compensation under section 415(c)(3) is also
used for purposes of a number of other plan qualification requirements
(see section 414(s)(1)). Section 415(c)(3)(D)(ii) provides that an
employee's compensation under section 415(c)(3) includes any amount that
is contributed by the employer at the election of the employee and that is
not includible in the gross income of the employee by reason of section
125. Section 415(c)(3)(D) is effective for years beginning after December
31, 1997.

Section 1.415-2(d) provides rules regarding acceptable definitions of
compensation under section 415(c)(3). Under section 1.415-2(d)(3)(iv),
amounts that receive special tax benefits, such as premiums for group-term
life insurance (to the extent the premiums are not includible in gross
income of the employee) are not included in compensation for purposes of
section 415(c)(3). Thus, pursuant to section 1.415-2(d)(3)(iv), premiums
for group health coverage are not treated as compensation for purposes of
section 415(c)(3), except for amounts that are contributed by the employer
at the election of the employee and that are not includible in the gross
income of the employee by reason of section 125.

Section 415(j) directs the Secretary to prescribe such regulations as
may be necessary to carry out the purposes of section 415. Section
1.415-2(d)(13) provides that the Commissioner may, in revenue rulings,
notices, and other guidance of general applicability, provide additional
definitions of compensation that are treated as satisfying section
415(c)(3).

Pursuant to section 1.415-2(d)(13), this revenue ruling provides that a
definition of compensation does not fail to satisfy the requirements of
section 415(c)(3) and section 1.415-2(d) merely because the definition
provides that amounts that are not available to an employee in cash in
lieu of group health coverage because the employee is not able to certify
that he or she has other health coverage are treated as subject to section
125. Under this definition, amounts are permitted to be treated as subject
to section 125 only if the employer does not otherwise request or collect
information regarding the employee's other health coverage as part of the
enrollment process for the health plan.

An employer may apply this rule for any plan year or limitation year
beginning after December 31, 1997.

Section 401(b) and the regulations thereunder provide a remedial
amendment period during which an amendment to a disqualifying provision
may be made retroactively effective, under certain circumstances, to
comply with the requirements of section 401(a). Section 1.401(b)-1(b)
provides that a disqualifying provision includes an amendment to an
existing plan that causes the plan to fail to satisfy the requirements of
section 401(a). Notice 2001-42 (2001-30 I.R.B. 70) provides a remedial
amendment period under Code section 401(b) ending not prior to the last
day of the first plan year beginning on or after January 1, 2005, in which
any needed retroactive amendment with regard to the Economic Growth and
Tax Relief Reconciliation Act of 2001, Public Law 107-16, (EGTRRA), may be
adopted. The availability of this remedial amendment period is conditioned
on the adoption of a good faith EGTRRA plan amendment no later than the
later of: (i) the end of the plan year in which the EGTRRA change in the
qualification requirement is required to be, or is optionally, put into
effect under the plan; or (ii) the end of the GUST <<ENDNOTE 1>> remedial
amendment period for the plan.


HOLDINGS

(1) Under Situation (1), contributions used to purchase group health
coverage under section 125 are not included in the gross income of the
employee solely because the plan uses an automatic enrollment process
whereby the employee's salary is reduced each year to pay for a portion of
the group health coverage under the plan unless the employee affirmatively
elects cash.

Under Situation (2), contributions used to purchase group health
coverage under section 125 are not included in the gross income of the
employee to the extent that an employee can elect cash. Section 125 does
not apply to the employee-only coverage of an employee in Situation (2)
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. The lack of a choice between cash and a qualified benefit for
these employees has no effect on whether the Plan satisfies the
requirements for the exclusion from gross income of accident or health
coverage under section 106(a).

(2) In determining compensation of employees for purposes of section
415(c)(3) under Holding (1), Situation (2) above, the employer can choose
to treat "deemed section 125 compensation" as subject to section 125. For
this purpose, "deemed section 125 compensation" is an excludable amount
that is not available to an employee in cash in lieu of group health
coverage under a section 125 arrangement because that employee is not able
to certify that he or she has other health coverage. Under this
definition, an amount is permitted to be treated as "deemed section 125
compensation" only if the employer does not otherwise request or collect
information regarding the employee's other health coverage as part of the
enrollment process for the health plan.

Pursuant to section 1.415-2(d)(13), a definition of compensation that
otherwise satisfies section 415(c)(3) will not fail to satisfy section
415(c)(3) merely because it is amended to incorporate deemed section 125
compensation, as provided in this revenue ruling. A definition of
compensation under section 415(c)(3) as amended to incorporate deemed
section 125 compensation may also be used for purposes of other plan
qualification requirements (e.g., section 414(s)). To the extent that a
definition of compensation incorporates deemed section 125 compensation,
it must apply uniformly to all employees with respect to whom amounts
subject to section 125 are included in compensation.

This additional definition of compensation under section 415(c)(3) may
be used in any plan year or limitation year beginning after December 31,
1997.

RETROACTIVE APPLICATION -- Pursuant to section 7805(b), for plan years
beginning after December 31, 1997, and prior to January 1, 2002, the
Service will not treat a qualified plan as having failed to satisfy the
requirements of section 401(a) merely because the plan treated "deemed
section 125 compensation" as compensation for purposes of section
415(c)(3), provided the plan is amended to provide the definition of
"deemed section 125 compensation" on or before the end of the 2002 plan
year and the amendment is effective for all years the plan operated in
accordance with this definition.

PROSPECTIVE APPLICATION. A plan that has not in operation been
including "deemed section 125 compensation" for purposes of section
415(c)(3) for plan or limitation years beginning before January 1, 2002,
may not be amended retroactively, but must be amended for years beginning
on or after January 1, 2002, in order for such amounts to be treated as
section 415(c)(3) compensation in such years. Such amendment must be
adopted no later than the end of the plan year in which it is effective.

Any plan amendment adopted in a timely manner pursuant to this revenue
ruling will, if it results in a disqualifying provision, have the same
remedial amendment period as the EGTRRA remedial amendment period. See
Notice 2001-42. The Appendix provides a model plan amendment that a plan
sponsor, or a sponsor of a pre-approved plan, may adopt to use the
alternative definition of compensation. Adoption of the model amendment
will not result in a disqualifying provision.


EFFECT ON OTHER REVENUE RULINGS

None


DRAFTING INFORMATION

The principal authors of this Revenue Ruling are Felix Zech of the
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities) and Andrew Zuckerman of Employee Plans (Tax Exempt
and Government Entities Division). For further information regarding this
Revenue Ruling, please contact the Employee Plans' taxpayer assistance
telephone service at 1-877-829-5500 (a toll-free number), between the
hours of 8:00 a.m. and 6:30 p.m. Eastern time, Monday through Friday. Mr.
Zech may be reached at 1-202-622-6080 and Mr. Zuckerman may be reached at
1-202-283-9655 (not toll-free numbers).


APPENDIX -- MODEL AMENDMENT

The following is a model amendment that a sponsor of a qualified plan
may choose to adopt if the sponsor maintains a health program in
conjunction with a section 125 arrangement but permits an employee to
elect cash in lieu of group health coverage only if the employee is able
to certify that he or she has other health coverage. The use of this
amendment will generally also apply to the definition of compensation for
purposes of Code section 414(s) unless the plan otherwise specifically
excludes all amounts described in section 414(s)(2).

A pre-approved plan (that is, a master or prototype or volume submitter
plan) may be amended by the document's sponsor to use the alternative
definition of compensation to the extent authorized. Alternatively,
adopting employers may adopt a plan amendment as an addendum to the plan
or adoption agreement. The inclusion of the model plan amendment below in
an addendum to a plan adopted to comply with EGTRRA will not cause a
pre-approved plan to be treated as an individually designed plan. A plan
sponsor that adopts the model amendment verbatim (or with only minor
changes) will have reliance that the form of its plan satisfies the
requirements of this revenue ruling, and the adoption of such an amendment
will not adversely affect the plan sponsor's or the adopting employer's
reliance on a favorable determination, opinion or advisory letter.

1. Effective date. This section ____ shall apply to plan years and
limitation years beginning on and after [insert the later of January 1,
1998, or the first day of the first plan year the plan was operated in
accordance with the definition in this section.]

2. For purposes of the definition of compensation under section(s)
____, amounts under section 125 include any amounts not available to a
participant in cash in lieu of group health coverage because the
participant is unable to certify that he or she has other health coverage.
An amount will be treated as an amount under section 125 only if the
Employer does not request or collect information regarding the
participant's other health coverage as part of the enrollment process for
the health plan. [Insert in the blank section references for the plan's
provisions that refer to amounts under section 125.]


<<ENDNOTES>>

1/ The term "GUST" refers to the following:

* The Uruguay Round Agreements Act, Pub. L. 103-465;

* The Uniformed Services Employment and Reemployment Rights Act of
1994, Pub. L. 103-353;

* The Small Business Job Protection Act of 1996, Pub. L. 104-188;

* The Taxpayer Relief Act of 1997, Pub. L. 105-34;

* The Internal Revenue Service Restructuring and Reform Act of 1998,
Pub. L. 105-206; and

* The Community Renewal Tax Relief Act of 2000, Pub. L. 106-554.


Unless section 19 of Rev. Proc. 2002-20, 2000-6 I.R.B. 553, as modified by
Notice 2001-42 and Rev. Proc. 2001-55, 2001-55 I.R.B. 552, applies, the
GUST remedial amendment period generally ended on February 28, 2002.

<<END RULING>>

TO CONTACT
DON FITCH CPA

Phone Don Fitch CPA Toll Free at (877)CPA-Help or (877)272-4357 or on our Direct Line at (760)674-1722.