IRS Revenue Ruling
2002-32

 Code Secs. 125, 106, 4980B

<<FULL TEXT>>

(Also sections 106, 4980B.)

Cafeteria Plans. In an asset sale, transferred employees who have
elected to participate in health flexible spending arrangements (FSAs)
under the seller's cafeteria plan may continue to exclude salary reduction
amounts and medical reimbursements from gross income without interruption
at the same level of coverage after becoming employees of the buyer.


REV. RUL. 2002-32

ISSUE

In an asset sale, may transferred employees who have elected to
participate in health flexible spending arrangements (FSAs) under seller's
I.R.C. section 125 cafeteria plan continue that benefit without
interruption at the same level of coverage after becoming employees of
buyer?


FACTS

Situation (1). Employer S maintains a cafeteria plan under section 125.
One of the benefits available under the plan is a health FSA that provides
for the reimbursement of participating employees' medical care expenses
that are not covered by other insurance. To participate in the health FSA,
employees elect pre-tax salary reduction for the right to receive medical
care expense reimbursements during the plan year up to a maximum amount
equal to the amount of the reduction elected for the year. Employer B is
an unrelated business entity.

During a plan year, S and B enter into an agreement under which B
acquires a portion of the assets of S and, as part of the acquisition,
employees of S who work in connection with the acquired assets terminate
employment with S and are transferred to and become employees of B.
Employer B has, or agrees to create, a cafeteria plan that offers a health
FSA through pre-tax salary reduction. It is the objective of both S and B
that the administration of the transferred employees' health FSAs
following the asset sale have as little impact on the transferred
employees as possible. Following the sale, S will continue its business
operations, including its health FSA. S and B agree that the transferred
employees who have elected to participate in S's FSA will continue in S's
FSA for the agreed upon period. S and B also agree on the extent, if any,
to which the existing salary reduction elections made by the transferred
employees for the FSAs under S's plan will continue as if made under B's
plan.

Situation (2). Same facts as in Situation (1) except that, as part of
the sale, B agrees to cover the transferred employees who have elected to
participate in S's health FSA under B's health FSA. Under B's health FSA,
the transferred employees will have the same level of coverage provided
under S's health FSA and will be treated as if their participation had
been continuous from the beginning of S's plan year. The transferred
employees' existing salary reduction elections will be taken into account
for the remainder of B's plan year as if made under B's health FSA. To
implement this arrangement, B amends its plan documents to provide that
transferred employees who elected to participate in S's health FSA become
participants in B's health FSA as of the beginning of S's plan year and at
the level of coverage provided under S's health FSA, except that
transferred employees who continue participation in S's health FSA after
the sale (e.g., by election of COBRA continuation coverage) are not
covered by B's health FSA for that year. In addition, B's health FSA is
amended to provide for reimbursement of medical care expenses incurred by
the transferred employees at any time during S's plan year (including
claims incurred before the sale), up to the amount of the employees'
election and reduced by amounts previously reimbursed by S. Thus, medical
care expenses incurred prior to the closing date of the sale but not
previously reimbursed as well as medical care expenses incurred after the
closing date of the sale are reimbursable under B's health FSA. S amends
its plan documents to provide that the transferred employees cease to be
eligible for medical care expense reimbursements from S as of the closing
date, except to the extent of any COBRA continuation coverage election. S
and B have determined that the agreements between them are consistent with
applicable law.


LAW AND ANALYSIS

In general, section 106(a) provides that gross income of an employee
does not include employer-provided coverage under an accident or health
plan. Under section 105(b), an employee may exclude amounts received
through employer-provided accident or health insurance if those amounts
are paid to reimburse expenses incurred by the employee during the period
of coverage for medical care (of the employee, the employee's spouse, or
the employee's dependents) for personal injuries or sickness.

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 in the plan.

Section 125(d) defines a cafeteria plan as a written benefit plan under
which all participants are employees, and the participants may choose
among two or more benefits consisting of cash and certain 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. A qualified benefit includes employer-provided
accident or health coverage under section 106(a) and reimbursements for
medical care expenses under section 105(b).

Section 1.125-4 of the Income Tax Regulations provides the
circumstances under which an employer can permit a cafeteria plan
participant to change an existing election during a period of coverage and
make a new election for the remaining portion of the period of coverage.
Generally, cafeteria plan participants are permitted to make election
changes if there has been a change in status event and the election change
satisfies the consistency rule. An election change satisfies the
consistency rule with respect to accident or health coverage 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.

Under the asset sale described in both Situation (1), where transferred
employees maintain their existing health FSAs under S's cafeteria plan,
and in Situation (2), where B agrees to cover the transferred employees
who have elected to participate in S's health FSA, there is no loss of
eligibility for coverage under section 1.125-4. Therefore, transferred
employees continue to be subject to their existing FSA elections and may
not change those elections during the remainder of the plan year of the
asset sale (unless an event occurs thereafter which permits an election
change under section 1.125-4).

For COBRA purposes, transferred employees in Situation (1) do not
suffer a loss of coverage under S's FSA during the plan year.
Consequently, if S's FSA satisfies the requirements of Q&A-8(c) in section
54.4980B-2, there is no obligation to make COBRA continuation coverage
available to the transferred employees with respect to their coverage
under S's FSA. However, if S's FSA does not satisfy the requirements of
Q&A-8(c) in section 54.4980B-2 and is otherwise subject to COBRA, then it
will be obligated to make COBRA continuation coverage available beginning
on the first day of the plan year after the current plan year. For
additional information, see section 54.4980B-2, Q&A-8 and section
54.4980B-9. In Situation (2), the obligation of S to extend to COBRA
qualified beneficiaries the right to elect COBRA continuation coverage is
not affected by the coverage provided by B.


HOLDING

In an asset sale, transferred employees who have elected to participate
in health FSAs under seller's cafeteria plan may continue to exclude the
salary reduction amounts and medical expense reimbursements from gross
income without interruption and at the same level of coverage after
becoming employees of buyer either when seller agrees to continue its
existing health FSAs for the transferred employees as described in
Situation (1) or when buyer agrees to adopt a continuation of seller's
health FSAs for the transferred employees as described in Situation (2).


EFFECT ON OTHER REVENUE RULING(S)

None


DRAFTING INFORMATION

The principal author of this revenue ruling is Shoshanna Chaiton of the
Office of Division Counsel/Associate Chief Counsel (Tax Exempt and
Government Entities). For further information regarding this revenue
ruling, contact her at (202) 622-6080 (not a toll-free call).

<<END RULING>>

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