Tax Treatment of Cafeteria Plans

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [TD 8878] RIN 1545-AU61

TITLE: Tax Treatment of Cafeteria Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

SUMMARY: This document contains final regulations relating to
section 125 cafeteria plans. The final regulations clarify the
circumstances under which a section 125 cafeteria plan election may
be changed. The final regulations permit an employer to allow a
section 125 cafeteria plan participant to revoke an existing
election and make a new election during a period of coverage for
accident or health coverage or group-term life insurance coverage.

DATES: Effective Date: These regulations are effective March 23,
2000. Applicability Date: These regulations are applicable for
cafeteria plan years beginning on or after January 1, 2001. See the
Scope of Regulations and Effective Date portion of this
preamble..The following are not qualified benefits: products
advertised, marketed, or offered as long-term care insurance;
medical savings accounts under section 106(b); qualified
scholarships under section 117; educational assistance programs
under section 127; and fringe benefits under section 132.

FOR FURTHER INFORMATION CONTACT: Janet A. Laufer or Christine L.
Keller at (202) 622-6080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

This document contains amendments to the Income Tax Regulations (26
CFR part 1) under section 125. Section 125 generally provides that
an employee in a cafeteria plan will not have an amount included in
gross income solely because the employee may choose among two or
more benefits consisting of cash and "qualified benefits." A
qualified benefit generally is any benefit that is excludable from
gross income under an express provision of the Internal Revenue
Code, including coverage under an employer-provided accident or
health plan under sections 105 and 106, group-term life insurance
under section 79, elective contributions under a qualified cash or
deferred arrangement within the meaning of section 401(k), dependent
care assistance under section 129, and adoption assistance under
section 137. Qualified 1 benefits can be provided under a cafeteria
plan either through insured arrangements or arrangements that are
not insured. FR 19321 (May 7, 1984) and 54 FR 9460 (March 7,
1989), respectively.

Those proposed regulations contain special rules with respect to
flexible spending arrangements. A flexible spending arrangement
(FSA) is defined in section 106(c)(2). Under section 106(c)(2), an
FSA is generally a benefit program under which the maximum
reimbursement reasonably available for coverage is less than 500% of
the value of the coverage.

62 FR 60196 (November 7, 1997) and 62 FR 60165 (November 7, 1997),
respectively. IRS Announcement 98-105 (1998-49 I.R.B. 21 (November
23, 1998)) states that the Service will amend the effective date of
those proposed and temporary regulations so that they will not be
effective before plan years beginning at least 120 days after
further guidance is issued.

In 1984 and 1989, proposed regulations were published relating to
the administration of cafeteria plans. In general, the 1984 and 1989
proposed regulations 2 require that for benefits to be provided on a
pre-tax basis under section 125, an employee may make changes during
a plan year only in certain circumstances Specifically, Q&A-8 of
'1.125-1 and Q&A-6(b), (c), and (d) of '1.125-2 permit participants
to make benefit election changes during a plan year pursuant to
changes in cost or coverage, changes in family status, and
separation from service.

In 1997, temporary and proposed regulations were issued addressing
the standards under which a cafeteria plan may permit a participant
to change his or her group health coverage election during a period
of coverage to conform with the special enrollment rights under
section 9801(f) (added to the Internal Revenue Code by the Health
Insurance Portability and Accountability Act of 1996 (HIPAA)) and to
change his or her group health or group-term life insurance coverage
in a variety of change in status situations. 4.4

These final regulations, which replace the 1997 temporary
regulations, clarify the circumstances under which a cafeteria plan
may permit an employee to revoke an existing election with respect
to accident or health coverage, or group-term life insurance
coverage, and make a new election during a period of coverage.

Explanation of Provisions

A. Summary. These regulations clarify the circumstances under which
a cafeteria plan may permit an employee to change his or her
cafeteria plan election with respect to accident or health coverage
or group-term life insurance coverage during the plan year. The
regulations generally follow the existing temporary regulations, and
include a variety of examples illustrating how the rules apply in
specific situations.

The final regulations include two principal changes that have been
made in response to public comments. First, the regulations differ
from the 1997 regulations with respect to change in status events
resulting from a change in employment. Commentators requested a
loosening of the rules regarding when a cafeteria plan election can
be changed. In response, the final rules incorporate a more flexible
rule under which any change in the employment status of the employee
(or a spouse or dependent of the employee) that affects that
individual's eligibility under a cafeteria plan or qualified
benefits plan constitutes a change in status for purposes of
permitting a mid-year election change. Second, in the event of a
change in an employee's marital status or the employment status of
the employee's spouse or dependent, the final regulations permit the
employee to elect either to increase group-term life insurance
coverage or to decrease group-term life insurance coverage. A
similar rule applies with respect to disability income plans.

These final regulations were developed as part of an integrated
package with proposed regulations that are being published elsewhere
in this issue of the Federal Register . Those proposed regulations
provide guidance on election changes on account of changes in status
with respect to dependent care assistance and adoption assistance
and provide guidance on election changes on account of changes in
cost or coverage with respect to dependent care assistance, adoption
assistance, accident or health coverage, and group-term life
insurance coverage. The integrated package of final and proposed
regulations is intended to provide clear standards for plan
administration and for administration of the tax law. The standards
are designed to accommodate the most common types of events of
independent significance that do not occur on a regular, periodic
basis and that are likely to affect an employee's decisions with
respect to qualified benefits coverage.

B. Changes in Status.

Commentators on the 1997 temporary and proposed regulations
requested that the description of changes in status be expanded to
include work-related changes of an employee, the employee's spouse,
or the employee's dependent in addition to termination or
commencement of employment or change in worksite. In response to
these comments, the description of changes in status has been
broadened to include a strike or lockout, and a commencement of or
return from an unpaid leave of absence. In addition, the final rules
incorporate a more flexible rule for other change in employment
status events. Specifically, if there is a change in the employment
status of the employee (or a spouse or dependent of the employee)
that affects that individual=s eligibility under a cafeteria plan or
qualified benefits plan, then that change constitutes a change in
status. For example, if an employee switches from salaried to
hourly-paid status, resulting in the employee ceasing to be eligible
for coverage under the plan, then that change constitutes a change
in status.

Some commentators expressed concern that the 1997 temporary and
proposed regulations did not permit an employee to make an election
change to cover additional individuals under an accident or health
plan when an employer changed its policy (e.g., to permit coverage
for a parent or for a domestic partner pursuant to local law
requirements). Under the 1997 temporary and proposed regulations, a
change in status includes an event that causes an employee's
dependent to satisfy or cease to satisfy the eligibility
requirements for coverage under a plan. Thus, if an individual who
is a dependent of an employee becomes eligible for coverage under
the employer's health plan as a result of an amendment made to the
plan during the year, that is a change in status event and,
accordingly, the cafeteria plan may permit an
election.Alternatively, the cafeteria plan may prohibit an employee
from participating in the cafeteria plan for that plan year upon
reemployment Change by the employee to cover the individual. These
final regulations retain the rule from the 1997 temporary and
proposed regulations.

These final regulations do not address when a bona fide termination
of employment occurs. However, these regulations retain the example
(Example 8 under paragraph (c)(4) of these final regulations) from
the 1997 temporary and proposed regulations addressing the situation
in which an employee terminates and resumes employment within 30
days. The effect of this example is to provide a practical safe
harbor that generally may be applied by cafeteria plans without
regard to other facts and circumstances. Under this example, if an
employee terminates and resumes employment within 30 days and the
cafeteria plan provides that the employee's election is
automatically reinstated, the employer is not required to determine
whether a bona fide change in status has occurred with respect to
termination of employment. Conversely, the cafeteria plan may permit
an employee who resumes employment more than 30 days following
termination to be automatically reinstated to the prior election or
to make a new election.

C. Consistency Rule.

As under the 1997 temporary and proposed regulations, the final
regulations require that an election change as a result of a change
in status also satisfy a consistency requirement. In response to
comments, the final regulations expand and clarify the consistency
requirement with respect to change in status events for group-term
life insurance. Under the 1997 regulations, in the case of a
commencement of employment, marriage, birth, adoption, or placement
for adoption, an employee could elect to increase (but not decrease)
group-term life insurance coverage. The 1997 regulations also
permitted an employee to elect to decrease (but not to increase)
group-term life insurance coverage in the case of divorce, legal
separation, annulment, or death of a spouse or dependent.
Commentators suggested that these rules were too restrictive. For
example, in the case of divorce, an employee may reasonably seek to
increase coverage because the employee may become the sole wage-
earner for the family unit as a result of the divorce. Accordingly,
the final regulations provide flexibility by stating that, in the
event of a change in an employee's marital status or the employment
status of the employee's spouse or dependent, an employee may elect
either to increase group-term life insurance coverage or to decrease
group-term life insurance coverage. Also, in response to comments, a
similar rule has been added that applies to election changes made
with respect to disability income coverage (i.e., accident or health
coverage that is neither for medical care as defined under section
213(d) nor for payments described in section 105(c)).

D. Other Changes.

Some commentators requested that the regulations prescribe a period
of time by which election changes, as a result of a change in
status, should be made. Consistent. No inference is intended from
these or any other examples in the final regulations concerning the
interpretation of special enrollment rights under section 9801(f).
with the approach taken in the 1997 regulations and in the interest
of providing employers and plan administrators flexibility, the
final regulations do not prescribe such a period. However, nothing
in the final regulations would prevent a cafeteria plan by its terms
from requiring that any election change (other than those made in
connection with rights for which there are specific minimum election
periods, such as under section 9801 (as added by HIPAA) and section
4980B (relating to COBRA coverage)), must be made within a specified
period after a change in status event. The consistency rule in the
final regulations does require that an election change made pursuant
to a change in status be @on account of@ a gain or loss of
eligibility for coverage. This requirement follows the @on account
of@ language contained in the 1989 proposed regulations under
'1.125-2, Q&A-6(c), and is intended to add a general condition that
the election change not be made so long after the event permitting
the election change that the election is not on account of the
event.

In accordance with comments, examples in the regulations clarify
that if, in accordance with special enrollment rights provided by
HIPAA , an employee, spouse, or new dependent is entitled to enroll
in a group health plan, a cafeteria plan may permit the employee to
elect to enroll pre-existing dependents in the underlying group
health plan. Likewise, the examples clarify that if, in accordance
with the change in Provisions in paragraph (b) of the final
regulation allowing election changes in connection with special
enrollment under section 9801(f) may overlap the provisions in
paragraphs (c) through (e) of the final regulations permitting
election changes in other circumstances. Thus, no inference is
intended that an election change permitted under paragraphs (c)
through (e) is not also permitted under paragraph (b).

status rules relating to a new spouse or dependent, an employee is
entitled to elect family coverage under a group health plan, then
other family members are permitted to become covered under the
family coverage as a result of the election change In response to
comments, the final regulations also clarify that, in the event of a
loss of Medicare or Medicaid entitlement by an employee or by the
employee's spouse or dependent, a cafeteria plan may permit the
employee to add health coverage under the employer=s accident or
health plan (and may permit cancellation or reduction in coverage if
an employee, spouse, or dependent who is enrolled in an accident or
health plan becomes entitled to Medicare or Medicaid).

Sco e of Regulations and Effective Date

These final regulations address all of the changes in status for
which a cafeteria plan may permit election changes with respect to
an accident or health plan or group-term life insurance plan.
However, future guidance under the cost or coverage change provision
(reserved at paragraph (f) of these final regulations and included
in paragraph (f) of the proposed regulations being published
elsewhere in this issue of the Federal Register ), rather than the
change in status rules, would determine whether a cafeteria plan may
permit affected employees to elect a new HMO option that is made.See
'1.125-3, published as a proposed rule at 60 FR 66229 (December 21,
1995) available during a period of coverage. Similarly, election
changes may be made under the special rules relating to changes in
elections by employees taking leave under the Family and Medical
Leave Act of 1993 (Public Law 103-3) (as referenced at paragraph 8
(g) of these final regulations).

Finally, these regulations do not override other cafeteria plan
requirements. For example, although an employee's termination of
employment is a change in status, some election changes made with
respect to coverage under a health FSA on account of the termination
of employment would fail to be consistent with the requirement that
the operation of such arrangements exhibit the risk-shifting and
risk-distribution characteristics of insurance under '1.125-1,
Q&A-17 and '1.125-2, Q&A-7 of the proposed regulations. Thus, a
cafeteria plan could not permit individuals terminating employment
to change their health FSA elections to match the amount of premiums
paid prior to termination (i.e., stop paying premiums), and continue
to receive health FSA reimbursements with respect to the remainder
of the period of coverage.

These regulations are applicable for cafeteria plan years beginning
on or after January 1, 2001. Until the beginning of the first plan
year beginning on or after January 1, 2001, taxpayers may rely on
these regulations. In addition, until the beginning of the first
plan year beginning on or after January 1, 2001, taxpayers may
continue to rely on the change in status rules in the 1997
regulations, as well as the change in family status rules in the
pre-1997 proposed regulations.

Pursuant to section 7805(e), the 1997 temporary regulations
'1.125-4T will expire within three years of the date of issuance
(November 7, 2000). This Treasury decision amends the 1997 temporary
regulations to add this expiration in the text of the regulations
('1.125-4T(l).

Special Analyses

It has been determined that this Treasury decision is not a
significant regulatory action as defined in Executive Order 12866.
Therefore, a regulatory assessment is not required. It also has been
determined that section 553(b) of the Administrative Procedure Act
(5 U.S.C. chapter 5) does not apply to these regulations, and
because the regulation does not impose a collection of information
on small entities, the Regulatory Flexibility Act (5 U.S.C. chapter
6) does not apply. Pursuant to section 7805(f) of the Internal
Revenue Code, these regulations will be submitted to the Chief
Counsel for Advocacy of the Small Business Administration for
comment on its impact on small business.

Drafting Information

The principal authors of these regulations are Janet A. Laufer and
Christine L. Keller, Office of the Associate Chief Counsel (Employee
Benefits and Exempt Organizations). However, other personnel from
the IRS and Treasury Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements. Adoption of
Amendments to the Regulations Accordingly, 26 CFR part 1 is amended
as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in
part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. '1.125-4 is added to read as follows:

'1.125-4 Permitted election changes.

(a) Election changes. A cafeteria plan may permit an employee to
revoke an election during a period of coverage and to make a new
election only as provided in paragraphs (b) through (g) of this
section. Section 125 does not require a cafeteria plan to permit any
of these changes. See paragraph (h) of this section for special
provisions relating to qualified cash or deferred arrangements, and
paragraph (i) of this section for special definitions used in this
section.

(b) Special enrollment rights -- (1) In general. A cafeteria plan
may permit an employee to revoke an election for coverage under a
group health plan during a period of coverage and make a new
election that corresponds with the special enrollment rights
provided in section 9801(f).

(2) Examples. The following examples illustrate the application of
this paragraph (b):

Example 1. (i) Employer M provides health coverage for its employees
pursuant to a plan that is subject to section 9801(f). Under the
plan, employees may elect either employee-only coverage or family
coverage. M also maintains a calendar year cafeteria plan under
which qualified benefits, including health coverage, are funded
through salary reduction. M's employee, A, is married to B and they
have a child, C. In accordance with M's cafeteria plan, Employee A
elects employee-only health coverage before the beginning of the
calendar year. During the year, A and B adopt a child, D. Within 30
days thereafter, A wants to revoke A's election for employee-only
health coverage and obtain family health coverage for A's spouse, C,
and D as of the date of D's adoption. Employee A satisfies the
conditions for special enrollment of an employee with a new
dependent under section 9801(f)(2), so that A may enroll in family
coverage under M's accident or health plan in order to provide
coverage effective as of the date of D's adoption.

(ii) M's cafeteria plan may permit A to change A's salary reduction
election to family coverage for salary not yet currently available.
The increased salary reduction is permitted to reflect the cost of
family coverage from the date of adoption......(A's adoption of D is
also a change in status, and the election of family coverage is
consistent with that change in status. Thus, under paragraph (c) of
this section, M's cafeteria plan could permit A to elect family
coverage prospectively in order to cover B, C, and D for the
remaining portion of the period of coverage.)

Example 2. (i) The employer plans and permissible coverage are the
same as in Example 1. Before the beginning of the calendar year,
Employee E elects employee- only health coverage under M's cafeteria
plan. Employee E marries F during the plan year. F's employer, N,
offers health coverage to N's employees, and, prior to the marriage,
F had elected employee-only coverage. Employee E wants to revoke the
election for employee-only coverage under M's cafeteria plan, and is
considering electing family health coverage under M's plan or
obtaining family health coverage under N's plan.

(ii) M's cafeteria plan may permit E to change E's salary reduction
election to reflect the change to family coverage under M's group
health plan because the marriage would result in special enrollment
rights under section 9801(f), pursuant to which an election of
family coverage under M's group health plan would be required to be
effective no later than the first day of the first calendar month
beginning after the completed request for enrollment is received by
the plan. (E's marriage to F is also a change in status under
paragraph (c) of this section, as illustrated in Example 1 of
paragraph (c)(4) of this section.)

(c) Changes in status -- (1) In general -- (i) Change in status
rule. A cafeteria plan may permit an employee to revoke an election
during a period of coverage with respect to a qualified benefits
plan to which this paragraph (c) applies and make a new election for
the remaining portion of the period (referred to in this section as
an election change) if, under the facts and circumstances --

(A) A change in status described in paragraph (c)(2) of this section
occurs; and

(B) The election change satisfies the consistency rule of paragraph
(c)(3) of this section.

(ii) Application to accident or health plans and group-term life
insurance plans. This paragraph (c) applies to plans providing
accident or health coverage and plans providing group-term life
insurance coverage.

(iii) Application to other qualified benefits. [RESERVED]

(2) Change in status events. The following events are changes in
status for purposes of this paragraph (c):

(i) Legal marital status. Events that change an employee's legal
marital status, including the following: marriage; death of spouse;
divorce; legal separation; and annulment.

(ii) Number of dependents. Events that change an employee's number
of dependents, including the following: birth; death; adoption; and
placement for adoption.

(iii) Employment status. Any of the following events that change the
employment status of the employee, the employee's spouse, or the
employee's dependent: a termination or commencement of employment; a
strike or lockout; a commencement of or return from an unpaid leave
of absence; and a change in worksite. In addition, if the
eligibility conditions of the cafeteria plan or other employee
benefit plan of the employer of the employee, spouse, or dependent
depend on the employment status of that individual and there is a
change in that individual's employment status with the consequence
that the individual becomes (or ceases to be) eligible under the
plan, then that change constitutes a change in employment under this
paragraph (c) (e.g., if a plan only applies to salaried employees
and an employee switches from salaried to hourly-paid with the
consequence that the employee ceases to be eligible for the plan,
then that change constitutes a change in employment status under
this paragraph (c)(2)(iii)).

(iv) Dependent satisfies or ceases to satisfy eligibility
requirements. Events that cause an employee's dependent to satisfy
or cease to satisfy eligibility requirements for coverage on account
of attainment of age, student status, or any similar circumstance.

(v) Residence. A change in the place of residence of the employee,
spouse, or dependent.

(3) Consistency rule -- (i) Application to accident or health
coverage and group-term life insurance. An election change satisfies
the requirements of this paragraph (c)(3) with respect to accident
or health coverage or group-term life insurance 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.

(ii) Application to other qualified benefits. [Reserved]

(iii) Application of consistency rule. If the change in status is
the employee's divorce, annulment or legal separation from a spouse,
the death of a spouse or dependent, or a dependent ceasing to
satisfy the eligibility requirements for coverage, an employee's
election under the cafeteria plan to cancel accident or health
insurance coverage for any individual other than the spouse involved
in the divorce, annulment or legal separation, the deceased spouse
or dependent, or the dependent that ceased to satisfy the
eligibility requirements for coverage, respectively, fails to
correspond with that change in status. Thus, if a dependent dies or
ceases to satisfy the eligibility requirements for coverage, the
employee's election to cancel accident or health coverage for any
other dependent, for the employee, or for the employee's spouse
fails to correspond with that change in status. In addition, if an
employee, spouse, or dependent gains eligibility for coverage under
a family member plan (as defined in paragraph (i)(5) of this
section) as a result of a change in marital status under paragraph
(c)(2)(i) of this section or a change in employment status under
paragraph (c)(2)(iii) of this section, an employee's election under
the cafeteria plan to cease or decrease coverage for that individual
under the cafeteria plan corresponds with that change in status only
if coverage for that individual becomes applicable or is increased
under the family member plan. However, if the change in status is a
change in the employee's marital status under paragraph (c)(2)(i) of
this section or a change in the employment status of the employee's
spouse or dependents under paragraph (c)(2)(iii) of this section, an
election to increase, or an election to decrease, group-term life
insurance or disability income coverage corresponds with that change
in status. (iv) Exception for COBRA. If the employee, spouse, or
dependent becomes eligible for continuation coverage under the group
health plan of the employee's employer as provided in section 4980B
or any similar state law, a cafeteria plan may permit the employee
to elect to increase payments under the employer's cafeteria plan in
order to pay for the continuation coverage.

(4) Examples. The following examples illustrate the application of
this paragraph (c):

Example 1. (i) Employer M provides health coverage (including a
health FSA) for its employees through its cafeteria plan. Before the
beginning of the calendar year, Employee A elects employee-only
health coverage under M's cafeteria plan and elects salary reduction
contributions to fund coverage under the health FSA. Employee A
marries B during the year. Employee B's employer, N, offers health
coverage to N's employees (but not including any health FSA), and,
prior to the marriage, B had elected employee-only coverage.
Employee A wants to revoke the election for employee-only coverage,
and is considering electing family health coverage under M's plan or
obtaining family health coverage under N's plan.

(ii) Employee A's marriage to B is a change in status under
paragraph (c)(2)(i) of this section, pursuant to which B has become
eligible for coverage under M's health plan under paragraph (c)(3)
(i) of this section. Two possible election changes by A correspond
with the change in status: Employee A may elect family health
coverage under M's plan to cover A and B; or A may cancel coverage
under M's plan, if B elects family health coverage under N's plan to
cover A and B. Thus, M's cafeteria plan may permit A to make either
election change.

(iii) Employee A may also increase salary reduction contributions to
fund coverage for B under the health FSA.

Example 2. (i) Employee C, a single parent, elects family health
coverage under a calendar year cafeteria plan maintained by Employer
O. Employee C and C's 21-year old child, D, are covered under O's
health plan. During the year, D graduates from college. Under the
terms of the health plan, dependents over the age of 19 must be
full-time students to receive coverage. Employee C wants to revoke
C's election for family health coverage and obtain employee-only
coverage under O's cafeteria plan.

(ii) D's loss of eligibility for coverage under the terms of the
health plan is a change in status under paragraph (c)(2)(iv) of this
section. A revocation of C's election for family coverage and new
election for employee-only coverage corresponds with the change in
status. Thus, O's cafeteria plan may permit C to elect employee-only
coverage.

Example 3. (i) Employee E is married to F and they have one child,
G. Employee E is employed by Employer P, and P maintains a calendar
year cafeteria plan that allows employees to elect no health
coverage, employee-only coverage, employee-plus-one-dependent
coverage, or family coverage. Under the plan, before the beginning
of the calendar year, E elects family health coverage for E, F, and
G. E and F divorce during the year and F loses eligibility for
coverage under P's plan. G does not lose eligibility for health
coverage under P's plan upon the divorce. E now wants to revoke E's
election under the cafeteria plan and elect no coverage.

(ii) The divorce is a change in status under paragraph (c)(2)(i). A
change in the cafeteria plan election to cancel health coverage for
F is consistent with that change in status. However, an election
change to cancel E's or G's health coverage does not satisfy the
consistency rule under paragraph (c)(3)(iii) of this section
regarding cancellation of coverage for an employee's other
dependents in the event of divorce. Therefore, the cafeteria plan
may not permit E to elect no coverage. However, an election to
change to employee-plus-one-dependent health coverage would
correspond with the change in status, and thus the cafeteria plan
may permit E to elect employee-plus- one-dependent health coverage.

Example 4. (i) Employer R maintains a calendar year cafeteria plan
under which full-time employees may elect coverage under one of
three benefit package options provided under an accident or health
plan: an indemnity option or either of two HMO options for employees
who work in the respective service areas of the two HMOs. Employee
A, who works in the service area of HMO #1, elects the HMO #1
option. During the year, A is transferred to another work location
which is outside the HMO #1 service area and inside the HMO #2
service area.

(ii) The transfer is a change in status under paragraph (c)(2)(iii)
of this section (relating to a change in worksite), and, under the
consistency rule in paragraph (c)(3) of this section, the cafeteria
plan may permit A to make an election change to either the indemnity
option or HMO #2.

Example 5.(i) Employer S maintains a calendar year cafeteria plan
that allows employees to elect coverage under an accident or health
plan providing indemnity coverage and coverage under a health FSA.
Prior to the beginning of the calendar year, Employee B elects
employee-only indemnity coverage, and elects salary reduction
contributions of $600 during the year to fund coverage under the
health FSA for up to $600 of reimbursements for the year. Employee
B's spouse, C, has employee-only coverage under an accident or
health plan maintained by C's employer. During the year, C
terminates employment and loses coverage under that plan. B now
wants to elect family coverage under S's accident or health plan and
increase B's FSA election.

(ii) C's termination of employment is a change in status under
paragraph (c)(2)(iii) of this section, and the election change
satisfies the consistency rule of paragraph (c)(3) of this section.
Therefore, the cafeteria plan may permit B to elect family coverage
under S's accident or health plan and to increase B's FSA coverage.
Example 6. (i) Employer T provides group-term life insurance
coverage as described under section 79. Under T's plan, an employee
may elect life insurance coverage in an amount up to $50,000. T also
maintains a calendar year cafeteria plan under which qualified
benefits, including the group-term life insurance coverage, are
funded through salary reduction.Employee D has a spouse and a child.
Before the beginning of the year, D elects $10,000 of group-term
life insurance coverage. During the year, D is divorced.

(ii) The divorce is a change in status under paragraph (c)(2)(i) of
this section. Under paragraph (c)(3)(iii) of this section, either an
increase or a decrease in coverage is consistent with this change in
status. Thus, T's cafeteria plan may permit D to increase or to
decrease D's group-term life insurance coverage. Example 7. (i)
Employee E is married to F and they have one child, G.

Employee E's employer, U, maintains a cafeteria plan under which
employees may elect no coverage, employee-only coverage, or family
coverage under a group health plan maintained by U, and may make a
separate vision coverage election under the plan. Before the
beginning of the calendar year, E elects family health coverage and
no vision coverage under U's cafeteria plan. Employee F=s employer,
V, maintains a cafeteria plan under which employees may elect no
coverage, employee-only coverage, or family coverage under a group
health plan maintained by V, and may make a separate vision coverage
election under the plan. Before the beginning of the calendar year,
F elects no health coverage and employee-only vision coverage under
V=s plan. During the year, F terminates employment with V and loses
vision coverage under V=s plan. Employee E now wants to elect family
vision coverage under U's group health plan.

(ii) F=s termination of employment is a change in status under
paragraph (c)(2)(iii) of this section, and the election change
satisfies the consistency rule of paragraph (c)(3) of this section.
Therefore, U's cafeteria plan may permit E to elect family vision
coverage (covering E and G as well as F) under U's group health
plan. Example 8. (i) Before the beginning of the year, Employee H
elects to participate in a cafeteria plan maintained by H's
employer, W. However, in order to change the election during the
year so as to cancel coverage, and by prior understanding with W, H
terminates employment and resumes employment one week later.

(ii) In this Example 8, under the facts and circumstances, a
principal purpose of the termination of employment was to alter the
election, and reinstatement of employment was understood at the time
of termination. Accordingly, H does not have a change in status
under paragraph (c)(2)(iii) of this section. (iii) However, H's
termination of employment would constitute a change in status,
permitting a cancellation of coverage during the period of
unemployment, if H's original cafeteria plan election for the period
of coverage was reinstated upon resumption of employment (for
example, if W's cafeteria plan contains a provision requiring an
employee who resumes employment within 30 days, without any other
intervening event that would permit a change in election, to return
to the election in effect prior to termination of employment).

(iv) If, instead, H terminates employment and cancels coverage
during a period of unemployment, and then returns to work more than
30 days following termination of employment, the cafeteria plan may
permit H the option of returning to the election in effect prior to
termination of employment or making a new election under the plan.
Alternatively, the cafeteria plan may prohibit H from returning to
the plan during that plan year.

(d) Judgment, decree, or order -- (1) Conforming election change.
This paragraph (d) applies to a judgment, decree, or order (order)
resulting from a divorce, legal separation, annulment, or change in
legal custody (including a qualified medical child support order as
defined in section 609 of the Employee Retirement Income Security
Act of 1974 (Public Law 93-406 (88 Stat. 829))) that requires
accident or health coverage for an employee's child or for a foster
child who is a dependent of the employee . A cafeteria plan will not
fail to satisfy section 125 if it --

(i) Changes the employee's election to provide coverage for the
child if the order requires coverage for the child under the
employee's plan; or

(ii) Permits the employee to make an election change to cancel
coverage for the child if the order requires the spouse, former
spouse, or other individual to provide coverage for the child.

(2) Example. The following example illustrates the application of
this paragraph

(d):

Example. (i) Employer M maintains a calendar year cafeteria plan
that allows employees to elect no health coverage, employee-only
coverage, employee-plus-one-dependent coverage, or family coverage.
M's employee, A, is married to B and they have one child, C. Before
the beginning of the year, A elects employee-only health coverage.
Employee A divorces B during the year and, pursuant to A's divorce
agreement with B, M's health plan receives a qualified medical child
support order (as defined in section 609 of the Employee Retirement
Income Security Act of 1974) during the plan year. The order
requires M's health plan to cover C.

(ii) Under this paragraph (d), M's cafeteria plan may change A's
election from employee-only health coverage to employee-plus-one-
dependent coverage in order to cover C.

(e) Entitlement to Medicare or Medicaid. If an employee, spouse, or
dependent who is enrolled in an accident or health plan of the
employer becomes entitled to coverage (i.e., becomes enrolled) under
Part A or Part B of Title XVIII of the Social Security Act
(Medicare)(Public Law 89-97 (79 Stat. 291)) or Title XIX of the
Social Security Act (Medicaid)(Public Law 89-97 (79 Stat. 343)),
other than coverage consisting solely of benefits under section 1928
of the Social Security Act (the program for distribution of
pediatric vaccines), a cafeteria plan may permit the employee to
make a prospective election change to cancel or reduce coverage of
that employee, spouse, or dependent under the accident or health
plan. In addition, if an employee, spouse, or dependent who has been
entitled to such coverage under Medicare or Medicaid loses
eligibility for such coverage, the cafeteria plan may permit the
employee to make a prospective election to commence or increase
coverage of that employee, spouse, or dependent under the accident
or health plan.

(f) Significant cost or coverage changes. [Reserved]

(g) Special requirements relating to the Family and Medical Leave
Act. An employee taking leave under the Family and Medical Leave Act
(FMLA)(Public Law 102- 530 (88 Stat. 829)) may revoke an existing
election of group health plan coverage and make such other election
for the remaining portion of the period of coverage as may be
provided for under the FMLA.

(h) Elective contributions under a qualified cash or deferred
arrangement. The provisions of this section do not apply with
respect to elective contributions under a qualified cash or deferred
arrangement (within the meaning of section 401(k)) or employee
contributions subject to section 401(m). Thus, a cafeteria plan may
permit an employee to modify or revoke elections in accordance with
section 401(k) and (m) and the regulations thereunder.

(i) Definitions. Unless otherwise provided, the definitions in
paragraphs (i)(1) though (8) of this section apply for purposes of
this section.

(1) Accident or health coverage. Accident or health coverage means
coverage under an accident or health plan as defined in regulations
under section 105.

(2) Benefit package option. A benefit package option means a
qualified benefit under section 125(f) that is offered under a
cafeteria plan, or an option for coverage under an underlying
accident or health plan (such as an indemnity option, an HMO option,
or a PPO option under an accident or health plan).

(3) Dependent. A dependent means a dependent as defined in section
152, except that, for purposes of accident or health coverage, any
child to whom section 152(e) applies is treated as a dependent of
both parents.

(4) Disability income coverage. Disability income coverage means
coverage under an accident or health plan that provides benefits due
to personal injury or sickness, but does not reimburse expenses
incurred for medical care (as defined in section 213(d)) of the
employee or the employee's spouse and dependents, and does not
provide for payments described in section 105(c).

(5) Family member plan. A family member plan means a cafeteria plan
or qualified benefit plan sponsored by the employer of the
employee's spouse or the employee's dependent.

(6) FSA, health FSA. An FSA means a qualified benefits plan that is
a flexible spending arrangement as defined in section 106(c)(2) . A
health FSA means a health or accident plan that is an FSA.

(7) Placement for adoption. Placement for adoption means placement
for adoption as defined in regulations under section 9801.

(8) Qualified benefits plan. A qualified benefits plan means an
employee benefit plan governing the provision of one or more
benefits that are qualified benefits under section 125(f). (j)
Effective date. This section is applicable for cafeteria plan years
beginning on or after January 1, 2001.

Par. 3. '1.125-4T is amended by revising paragraph (l) to read as
follows: '1.125-4T Permitted election changes (temporary).

* * * * *

(l) Effective date. This section is applicable for plan years
beginning after December 31, 1998, and on or before November 6,
2000.

Robert E. Wenzel
Deputy Commissioner of Internal Revenue
Approved: 2/23/00
Jonathan Talisman
Acting Assistant Secretary of the Treasury (Tax Policy)

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