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The Section 125 Safe Harbor from Constructive Receipt

Question: Why do employers need a Section 125 cafeteria plan for employee pre-tax contributions?

Short Answer: The Section 125 cafeteria plan is the exclusive means by which an employer can offer employees an election between taxable income and nontaxable health and welfare benefits on a tax-advantaged basis without application of the doctrine of constructive receipt.

General Rule: Constructive Receipt (Taxable)

The general rule is that employees must include in taxable income any compensation amount which they actually or constructively receive.

The term “constructive” is commonly used in the legal context.  Legal dictionaries typically define the term to mean that which exists, not in fact, but by operation of law.  Another approach is to define the term as something which by interpretation under the facts and circumstances has an effect in law, though not necessarily in fact.  A simpler shorthand is to think of “constructive” as a legal fiction for treating a situation as if it were actually so.

Common areas of the law with “constructive” application include constructive possession, constructive termination, constructive eviction, constructive notice, constrictive knowledge, and constructive fraud.

In this case, the “constructive” concept at issue is “constructive receipt” of income.  Treasury regulations broadly define the term as follows:

Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given.” (Treas. Reg. §1.451-2(a))

This constructive receipt issue comes into play each time an employee has a choice between receiving taxable income (generally cash) and making salary reduction elections to contribute toward a non-taxable health and welfare benefit (generally the employee-share of the premium or an FSA contribution).

Operating Without a Cafeteria Plan: Constructive Receipt of Taxable Cash Option

Employers that offer employees the choice between taxable income and non-taxable benefits outside of a Section 125 cafeteria plan must include in taxable income any amount which the employee could have elected to receive in taxable cash.

In other words, the election between taxable income (including cash) and non-taxable benefits results in gross income to the employee—even if the employee elects the (otherwise non-taxable) benefits!

Example 1:

  • ABC employer has not established a Section 125 cafeteria plan.
  • The ABC group health plan premium is $500/month.
  • The employer contribution is $350/month.
  • The employee-share of the premium is $150/month.
  • Employee Debbie elects to enroll in (and pay the required employee contribution to) the plan.

Result 1:

  • Debbie is in constructive receipt of the $150 in taxable cash she could have received had she not elected to enroll in the ABC group health plan.
  • ABC must therefore include the 50 cash option amount in Debbie’s gross income as taxable even though she elected to enroll in (and pay for) the health plan.

 The (still proposed form 2007) cafeteria plan regulations distill this example in a straightforward manner as follows:

[I]f a plan offering an employee an election between taxable benefits (including cash) and nontaxable qualified benefits does not meet the section 125 requirements, the election between taxable and nontaxable benefits results in gross income to the employee, regardless of what benefit is elected and when the election is made.” (Prop. Treas. Reg. §1.125-1(b)(1))

This example and the regulations highlight the basic constructive receipt principle that you generally cannot “turn your back on taxable income” to escape income taxes.  By choosing the otherwise non-taxable health benefits, the employee has turned her back on the taxable income from standard cash compensation.  As a result, the employee is treated as being in constructive receipt of the taxable income—and thereby taxed on the value of that taxable income choice—despite turning her back on it.

Operating With a Cafeteria Plan: Employee Pre-Tax Contributions

Section 125 cafeteria plans allow employers to avoid constructive receipt issues for employees electing non-taxable qualified benefits under the POP, health FSA, dependent care FSA, or other cafeteria plan qualified benefit component.

The cafeteria plan is designed as a safe harbor for employers to avoid the doctrine of constructive receipt in making health and welfare plan elections.  As the (still proposed form 2007) cafeteria plan regulations succinctly put it:

Section 125 provides that cash (including certain taxable benefits) offered to an employee through a nondiscriminatory cafeteria plan is not includible in the employee’s gross income merely because the employee has the opportunity to choose among cash and qualified benefits…through a cafeteria plan.”(Prop. Treas. Reg. §1.125-1(b)(1))

The result is that employees can make a choice between taxable cash income and non-taxable cafeteria plan benefits, including to make a salary reduction election to pay for health and welfare benefits on a pre-tax basis, and not be subject to taxable income on the cash the employee could have received.

Example 2:

  • XYZ employer maintains a Section 125 cafeteria plan with a POP component.
  • The XYZ group health plan premium is $500/month.
  • The employer contribution is $350/month.
  • The employee-share of the premium is $150/month.
  • Employee Wendy elects to enroll in the plan with a corresponding cafeteria plan election to pay the employee-share of the premium.

Result 2:

  • Wendy makes her $150/month contribution on a pre-tax basis through the POP component of the Section 125 cafeteria plan.
  • Even though Wendy has “turned her back” on taxable income by electing non-taxable benefits, the cafeteria plan prevents the adverse tax consequences associated with constructive receipt.
  • Wendy is not in constructive receipt of the $150 she could have received in taxable cash because the cafeteria plan provides a safe harbor from the doctrine of constructive receipt.

As an added bonus, both the employer and employee also avoid FICA taxes (6.2% Social Security, 1.45% Medicare) on the contributions made on a pre-tax basis through the cafeteria plan.  Section 125 can therefore be used by employees to avoid both income taxes and payroll taxes (depending on the underlying benefit) through pre-tax contributions.  Because there are employer and employee shares of FICA taxes, employers have an incentive for employees to take advantage of cafeteria plan offerings.

  • For more information on everything Section 125, see our ABD Office Hours Webinar: Section 125 Cafeteria Plans.

Adopting a Cafeteria Plan: Required Content 

The Section 125 regulations outline the following required content for an employer’s cafeteria plan to qualify for the safe harbor from constructive receipt:

  • A specific description of each of the benefits available through the plan, including the periods during which the benefits are provided (the periods of coverage);
  • The plan’s rules governing participation, and specifically requiring that all participants in the plan be employees;
  • The procedures governing employees’ elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective, and providing that elections are irrevocable (outside of the permitted election change events);
  • The manner in which employer contributions may be made under the plan (employee salary reduction election, employer nonelective contributions, flex credits, etc.);
  • The maximum amount of elective contributions (i.e., salary reduction) available to any employee through the plan (e.g., $2,750 health FSA, $10,500 dependent care FSA);
  • The plan year of the cafeteria plan;
  • The special rules that apply to FSAs (e.g., use-it-or-lose-it rule, uniform coverage for health FSA);
  • A description of the plan’s grace period or carryover period (if offered); and
  • If the plan offers PTO buying/selling (uncommon), special ordering rules that apply.

Adopting a Cafeteria Plan: Prospective Adoption/Amendment/Restatement Required 

The Section 125 cafeteria plan needs to be signed (adopted) on or before the first day of the plan year that it will be effective.

Just as the initial cafeteria plan document must be adopted prospectively to be effective, so to must any subsequent plan amendment or restatement.  In other words, a Section 125 cafeteria plan amendment or restatement cannot have retroactive effect.  The employer must sign the amendment or restatement on or before the date for which it is to be effective.

If an employer signs a cafeteria plan document, amendment, or restatement with an effective date prior to the date the document is signed (i.e., with a retroactive effective date), the IRS could find that the document is not a valid cafeteria plan.  In that situation, employees would not receive the Section 125 safe harbor from constructive receipt, potentially resulting in all employee premium and FSA pre-tax contributions becoming taxable to the employee.

In summary, the employer must sign the cafeteria plan document, amendment, or restatement on or before the effective date of the plan to be valid under Section 125.

 Cafeteria Plan Options: Qualified and Non-Qualified Benefits

Section 125 permits employees to choose between taxable cash and qualified benefits through the cafeteria plan.  The result is the safe harbor from constructive receipt for employee pre-tax contributions through a cafeteria plan is available only for underlying programs that are a “qualified benefit.”

Section 125 Qualified Benefits

  • Group Health Plan (Medical, Dental, Vision)
  • Health FSA, Dependent Care FSA
  • HSA
  • Group Term Life ($30k coverage cap)
  • AD&D
  • Hospital Indemnity/Cancer Insurance
  • Disability (generally contributions or benefits are taxable)
  • 401(k) Plan (cashable flex credits, uncommon)
  • Adoption Assistance (no FICA exemption, uncommon)
  • PTO Buying/Selling (uncommon)

 Non-Qualified Benefits

  • Commuter Transit/Vanpool/Parking (§132 provides for employee pre-tax contributions)
  • HRA (no employee contributions permitted)
  • Tuition Assistance (employer tax-free reimbursement permitted under §127 or §132)
  • 403(b) Plan (different from 401(k)!)
  • Long-Term Care Insurance
  • Individual Medical Policies (prohibited by ACA, only permitted if purchased off Exchange for EEs covered by an ICHRA)

For more information on everything Section 125, see our ABD Office Hours Webinar: Section 125 Cafeteria Plans.

Regulations

Treas. Reg. §1.451-1(a):

(a) General rule. Gains, profits, and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer unless includible for a different year in accordance with the taxpayer’s method of accounting.

Treas. Reg. §1.451-2(a):

(a) General rule. Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Prop. Treas. Reg. §1.125-1(b)(1):

(1) Cafeteria plans. Section 125 is the exclusive means by which an employer can offer employees an election between taxable and nontaxable benefits without the election itself resulting in inclusion in gross income by the employees. Section 125 provides that cash (including certain taxable benefits) offered to an employee through a nondiscriminatory cafeteria plan is not includible in the employee’s gross income merely because the employee has the opportunity to choose among cash and qualified benefits (within the meaning of section 125(e)) through the cafeteria plan. Section 125(a), (d)(1). However, if a plan offering an employee an election between taxable benefits (including cash) and nontaxable qualified benefits does not meet the section 125 requirements, the election between taxable and nontaxable benefits results in gross income to the employee, regardless of what benefit is elected and when the election is made. An employee who has an election among nontaxable benefits and taxable benefits (including cash) that is not through a cafeteria plan that satisfies section 125 must include in gross income the value of the taxable benefit with the greatest value that the employee could have elected to receive, even if the employee elects to receive only the nontaxable benefits offered. The amount of the taxable benefit is includible in the employee’s income in the year in which the employee would have actually received the taxable benefit if the employee had elected such benefit. This is the result even if the employee’s election between the nontaxable benefits and taxable benefits is made prior to the year in which the employee would actually have received the taxable benefits. See paragraph (q) in §1.125-1 for nonqualified benefits.

Prop. Treas. Reg. §1.125-1(c):

(c) Written plan requirements.

(1) General rule. A cafeteria plan must contain in writing the information described in this paragraph (c), and depending on the qualified benefits offered in the plan, may also be required to contain additional information described in paragraphs (c)(2) and (c)(3) of this section. The cafeteria plan must be adopted and effective on or before the first day of the cafeteria plan year to which it relates. The terms of the plan must apply uniformly to all participants. The cafeteria plan document may be comprised of multiple documents. The written cafeteria plan must contain all of the following information—

(i) A specific description of each of the benefits available through the plan, including the periods during which the benefits are provided (the periods of coverage);

(ii) The plan’s rules governing participation, and specifically requiring that all participants in the plan be employees;

(iii) The procedures governing employees’ elections under the plan, including the period when elections may be made, the periods with respect to which elections are effective, and providing that elections are irrevocable, except to the extent that the optional change in status rules in §1.125-4 are included in the cafeteria plan;

(iv) The manner in which employer contributions may be made under the plan, (for example, through an employee’s salary reduction election or by nonelective employer contributions (that is, flex-credits, as defined in paragraph (b) in §1.125-5) or both);

(v) The maximum amount of employer contributions available to any employee through the plan, by stating:

(A) The maximum amount of elective contributions (i.e., salary reduction) available to any employee through the plan, expressed as a maximum dollar amount or a maximum percentage of compensation or the method for determining the maximum dollar amount; and

(B) For contributions to section 401(k) plans, the maximum amount of elective contributions available to any employee through the plan, expressed as a maximum dollar amount or maximum percentage of compensation that may be contributed as elective contributions through the plan by employees.

(vi) The plan year of the cafeteria plan;

(vii) If the plan offers paid time off, the required ordering rule for use of nonelective and elective paid time off in paragraph (o)(4) of this section;

(viii) If the plan includes flexible spending arrangements (as defined in §1.125-5(a)), the plan’s provisions complying with any additional requirements for those FSAs (for example, the uniform coverage rule and the use-or-lose rules in paragraphs (d) and (c) in §1.125-5);

(ix) If the plan includes a grace period, the plan’s provisions complying with paragraph (e) of this section; and

(x) If the plan includes distributions from a health FSA to employees’ HSAs, the plan’s provisions complying with paragraph (n) in §1.125-5.

(5) Amendments to cafeteria plan. Any amendment to the cafeteria plan must be in writing. A cafeteria plan is permitted to be amended at any time during a plan year. However, the amendment is only permitted to be effective for periods after the later of the adoption date or effective date of the amendment. For an amendment adding a new benefit, the cafeteria plan must pay or reimburse only those expenses for new benefits incurred after the later of the amendment’s adoption date or effective date.

(6) Failure to satisfy written plan requirements. If there is no written cafeteria plan, or if the written plan fails to satisfy any of the requirements in this paragraph (c) (including cross-referenced requirements), the plan is not a cafeteria plan and an employee’s election between taxable and nontaxable benefits results in gross income to the employee.


Brian Gilmore

About the author

Brian Gilmore

Brian Gilmore is the Lead Benefits Counsel at Newfront. He assists clients on a wide variety of employee benefits compliance issues. The primary areas of his practice include ERISA, ACA, COBRA, HIPAA, Section 125 Cafeteria Plans, and 401(k) plans. Brian also presents regularly at trade events and in webinars on current hot topics in employee benefits law. Connect with Brian on LinkedIn.


The information provided is of a general nature and an educational resource. It is not intended to provide advice or address the situation of any particular individual or entity. Any recipient shall be responsible for the use to which it puts this document. Newfront shall have no liability for the information provided. While care has been taken to produce this document, Newfront does not warrant, represent or guarantee the completeness, accuracy, adequacy, or fitness with respect to the information contained in this document. The information provided does not reflect new circumstances, or additional regulatory and legal changes. The issues addressed may have legal, financial, and health implications, and we recommend you speak to your legal, financial, and health advisors before acting on any of the information provided.

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