Employee Benefits Bulletin, June 2002
AUTOMATIC ENROLLMENT FOR CAFETERIA PLANS
IRS GIVES THE OK IN REVENUE RULING 2002-27
Automatic enrollment is a process in which employees are automatically enrolled in a benefit plan unless they affirmatively elect not to participate (as opposed to the method in which only employees who return the benefit plan paperwork-an affirmative election to participate-are enrolled). For several years, employers have utilized automatic enrollment in 401(k) retirement plans as a method of ensuring that the maximum number of employees participate in the plan, thus helping the nondiscrimination testing. However, until now, the IRS has not provided written guidance to allow employers to use automatic enrollment for cafeteria plans.
Participants in a cafeteria plan may choose between cash and nontaxable qualified benefits (such as health insurance coverage, excludable from income by IRC §106). Normally, such a choice will trigger a tax doctrine called constructive receipt, in which an individual is treated as receiving taxable income simply because he has the opportunity, before a cash benefit actually becomes available, to elect among cash and nontaxable benefits (essentially "turning his back" on taxable income). However, Internal Revenue Code §125 provides a specific exception from constructive receipt for participants of cafeteria plans. Before the IRS issued Revenue Ruling 2002-27 this spring, employers feared that participants in a cafeteria plan using automatic enrollment would void the special exception and trigger constructive receipt of taxable income.
Revenue Ruling 2002-27 sets the guidelines for automatic enrollment in cafeteria plans based on two fact patterns.
Situation 1: The first involves an employer which maintains a cafeteria plan offering group health insurance coverage with the option of employee-only or family coverage. Employees are automatically enrolled in employee-only coverage unless they affirmatively elect cash or family coverage. All employees are given a notice that explains the automatic enrollment process and their rights to decline coverage (have no salary reduction). New hires must affirmatively elect cash or family coverage when hired or within a reasonable time before the first pay period ends. Current employees must opt out or choose family coverage before the beginning of the next plan year. An election made for any prior year carries over to the next succeeding plan year unless changed.
Situation 2: Same as Situation 1 except that an employee may not opt out (elect to receive cash only) unless the employee certifies that she has other health coverage.
The IRS held in the Revenue Ruling that participants in Situation 1 are still protected from taxation on the cost of the health insurance coverage by the constructive receipt exception for cafeteria plans in IRC §125. Situation 1 does not void the exception because participants still have the option, even with the automatic enrollment method, to "choose" or "affirmatively elect" between cash (no deferral) and a qualified benefit (health coverage).
In Situation 2, contributions used to purchase the health coverage are also nontaxable under IRC §125 EXCEPT for employees who are forced to choose employee-only health coverage because they could not provide proof of other insurance. The IRS held there is not adequate "choice" involved for those participants to fall under the §125 exception, and it appears that their salary deferrals will be taxed. (It is important to note here that the value-not cost-of the group health coverage is still excludable from employees' income through IRC §106.)
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