Tax Treatment of Cafeteria Plans

DEPARTMENT OF THE TREASURY
Internal Revenue Service 26 CFR Part 1 [REG-117162-99] RIN 1545-AX59

TITLE: Tax Treatment of Cafeteria Plans

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Partial withdrawal of notice of proposed rulemaking;
amendment to notice of proposed rulemaking; and notice of proposed
rulemaking.

SUMMARY: This document withdraws portions of the notice of proposed
rulemaking published in the Federal Register on March 7, 1989 and
amends proposed regulations under section 125. These proposed
regulations clarify the circumstances under which a section 125
cafeteria plan election may be changed. The proposed 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, group-term life
insurance coverage, dependent care assistance, and adoption
assistance.

DATES: Written and electronic comments and requests for a public
hearing must be received by June 22, 2000.

ADDRESSES: Send submissions to: CC:DOM:CORP:R
(REG-117162-99),.Revenue Act of 1978, Public Law 95-600 (November 6,
1978): Sen. Rep. 95-1263, 1 95 Cong., 2d Sess., 74-78, 186-187
(October 1, 1978); H.R. Rep. No. 95-1445, 95 th th Cong., 2d Sess.,
63-66 (August 4, 1978); H.R. Rep. No. 95-250, 96 Cong., 2d Sess., th
206-207, 253-254 (October 15, 1978).

"Qualified benefits" are generally any benefits excluded from
income, including coverage 2 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. 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 132.2 room
5226, Internal Revenue Service, POB 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand delivered between the
hours of 8 a.m. and 5 p.m. to: CC:DOM:CORP:R (REG-117162-99),
Courier's Desk, Internal Revenue Service, 1111 Constitution Avenue
NW., Washington, DC. Alternatively, taxpayers may submit comments
electronically via the internet by selecting the "Tax Regs" option
on the IRS Home Page, or by submitting comments directly to the IRS
internet site at http://www.irs.gov/tax_regs/regslist.html.

FOR FURTHER INFORMATION CONTACT: Concerning the regulations, Janet
A. Laufer or Christine L. Keller at (202) 622-6080; concerning
submissions or to request a public hearing, LaNita Van Dyke at (202)
622-7180. These are not toll-free numbers.

SUPPLEMENTARY INFORMATION:

Background

Section 125 permits an employer to offer employees the choice
between taxable 1 income and certain nontaxable or "qualified
benefits" through a cafeteria plan, without 2.Qualified benefits can
be provided under a cafeteria plan either through insured
arrangements or arrangements that are not insured.

49 FR 19321 (May 7, 1984) and 54 FR 9460 (March 7, 1989),
respectively Those proposed regulations contain special rules with
respect to flexible spending 4 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), 5
respectively. IRS Announcement 98-105 (1998-49 I.R.B. 21 (November
23, 1998)) states that the Service will amend the effective date of
these temporary regulations the employees having to recognize the
taxable income. In 1984 and 1989, proposed regulations were
published relating to the administration of cafeteria plans. In
general, 3 the 1984 and 1989 proposed regulations 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, ��1.125-1, Q&A-8 and 1.125-2, Q&A-6(b),
4 (c) and (d) 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. The 1997 regulations
are being published as final regulations 5.(�1.125-4T) and proposed
regulations (�1.125-4) so that they will not be effective before
plan years beginning at least 120 days after further guidance is
issued. elsewhere in this issue of the Federal Register.

Explanation of Provisions

A. Summary.

The proposed regulations being published in this notice of proposed
rulemaking were developed as part of an integrated package with the
final regulations that are being published at the same time. These
proposed regulations supplement the final regulations by permitting
a mid-year cafeteria plan election change in connection with
dependent care assistance and adoption assistance under change in
status standards that are the same as the standards in the final
regulations for accident or health plans and for group-term life
insurance, and by adding change in status standards that are
specific to dependent care and adoption assistance. These proposed
regulations also refine and expand upon the approach adopted in the
1989 proposed regulations (at �1.125-2, Q&A-6(b)) by providing that
a cafeteria plan may permit employees to make mid-year election
changes with respect to group-term life insurance, dependent care
assistance, and adoption assistance as well as accident or health
coverage, on account of changes in cost or coverage. This expansion
of the cost or coverage rules would also allow employees to make
election changes if, during a period of coverage, (1) a new benefit
package option is offered, or a benefit package option is
eliminated, under the plan or (2) a coverage change is made under a
plan of the employer of an employee's spouse or dependent. These
proposed regulations include a variety of.5 examples illustrating
how the rules apply in specific situations.

B. Change in Status.

The proposed regulations published in this notice of proposed
rulemaking complement the final regulations being published
elsewhere in this issue of the Federal Register with respect to
special enrollment rights and changes in status for accident or
health coverage and group-term life insurance coverage. These
proposed regulations take into account comments received on the 1997
temporary and proposed regulations, including comments suggesting
the desirability of uniformity in the rules for different types of
qualified benefits to the extent appropriate given the nature of the
benefits.

In response to comments, the new proposed regulations address
circumstances under which a cafeteria plan may permit an employee to
change an election for dependent care assistance under section 129
and adoption assistance under section 137 during a plan year. The
proposed change in status rules for dependent care assistance and
adoption assistance parallel the change in status rules for accident
or health coverage and group-term life insurance coverage contained
in the final regulations, with some additional rules specific to
dependent care and adoption assistance. For example, while a change
in the number of dependents is a status change for other types of
qualified benefits, a change in the number of qualifying
individuals, as defined in section 21(b)(1), is a change in status
for purposes of dependent care assistance. Likewise, these proposed
regulations allow an additional change in status event for adoption
assistance (the commencement or termination of an adoption
proceeding). The consistency rule in the proposed regulations is the
same as.Conforming changes have also been made to Q&A-8 of the 1984
proposed regulations under �1.125-1 the consistency rule in the
final regulations, with certain provisions that are specific to
dependent care and adoption assistance changes.

C. Change in Cost or Coverage.

The new proposed regulations also address election changes to
reflect significant cost and coverage changes for all types of
qualified benefits provided under a cafeteria plan. The new proposed
regulations refine and expand upon the approach taken in the 1989
proposed regulations at �1.125-2, Q&A-6 with respect to changes in
cost or coverage under the plan. For example, in response to
comments, the new proposed regulations provide that if a plan adds a
new benefit package option (such as a new HMO option), the cafeteria
plan may permit affected participants to elect that option and make
a corresponding election change with respect to other benefit
package options during a period of coverage.

The new proposed regulations also generally extend the cost or
coverage rules under �1.125-2, Q&A-6(b) to permit election changes
for self-insured accident or health plans, group-term life
insurance, dependent care assistance and adoption assistance
coverage under a cafeteria plan. Thus, for example, if the cost of a
self-insured accident or health plan increases, a plan may
automatically make a corresponding change in the salary reduction
charge. In addition, the new proposed regulations treat a change of
dependent care provider as similar to the addition of a new HMO
option under an accident or health plan, with the result that a
corresponding election change can be made when one dependent care
provider is replaced by another. While the coverage change rules
apply to dependent care regardless of whether the dependent care
provider is related to the employee, the cost change rules do not
apply to dependent care if the dependent care provider is a relative
of the employee making the election.

Commentators on the 1997 temporary and proposed regulations also
raised a concern that when the plan of the employer of a spouse
conducts annual open enrollment for group health benefits beginning
at a different time of the year than the annual open enrollment for
group health benefits offered by the employee's employer, the
employee is unnecessarily restricted from making election changes
that correspond with elections made by the employee's spouse. These
commentators suggested that if one spouse makes an election change
during an open enrollment period, a corresponding change should be
permitted for the other spouse. In response to these comments, the
new proposed regulations provide that a cafeteria plan may permit an
employee to make an election change, during a period of coverage,
corresponding with an open enrollment period change made by a spouse
or dependent when the plan of that individual's employer has a
different period of coverage.

In addition, the new proposed regulations provide that a cafeteria
plan may permit an employee to make an election change in the event
that a spouse or dependent makes an election change under a
cafeteria plan (or qualified benefits plan) maintained by that
individual's employer, provided that the spouse or dependent's
election change satisfies the election change rules under the
proposed regulation. For.The loss of coverage under a government
program may give rise to a special enrollment right under section
9801(f) and, thus, the issue addressed here is relevant only in
cases in which the special enrollment rules do not apply.

Example, under this provision, if the plan of a spouse's employer
adds a new HMO option to its group health plan, and the spouse
elects to enroll the family in that new option, a cafeteria plan may
permit the employee to drop family coverage. These new rules apply
only if the change made by the employee is on account of and
corresponds with the change made under the other employer's plan.
This expansion of the existing cost or coverage change rules permits
employees to make election changes to ensure consistent coverage of
family members and eliminate duplicate coverage. The cost or
coverage rules in the new proposed regulations have not been
extended to health flexible spending arrangements. This ensures that
those arrangements will not permit election changes in a manner that
is inconsistent with the requirement, under ��1.125-1, Q&A-17 and
1.125-2, Q&A-7 of the existing proposed regulations, that such
arrangements exhibit the risk-shifting and risk-distribution
characteristics of insurance.

Although the final regulations being published elsewhere in this
issue of the FEDERAL REGISTER permit election changes in the event
an individual becomes eligible (or loses eligibility) for Medicare
or Medicaid, these proposed regulations do not address election
changes to reflect an individual's eligibility for other government
programs that pay for or subsidize health coverage. For example, the
new rules do not address the possibility that an employee's child
may cease to be eligible for coverage.Added to the Social Security
Act by section 4901 of the Balanced Budget Act of 1997, 8 Public Law
105-33 (August 5, 1997).

Under a state's children's health insurance program (CHIP) designed
in accordance with Title XXI of the Social Security Act. Comments
are requested on whether eligibility or ineligibility for such a
government program should be added to the types of events that allow
a cafeteria plan election change (including any special
administrative difficulties that employers might have in identifying
this type of event) and, if so, the types of government programs
that should be permitted to be taken into account.

D. Effective Date and Reliance.

The new proposed regulations do not specify a proposed effective
date. Any effective date will be prospective, and comments are
requested on the extent of lead time necessary for employers to be
able to implement the new proposed regulations after they are
adopted as final regulations.

Until the effective date of further guidance, taxpayers may rely on
the new proposed regulations. In addition, until the effective date
of further guidance, taxpayers may continue to rely on the change in
family status rules in the existing proposed regulations (at
�1.125-2, Q&A-6(c)) with respect to benefits other than accident and
health coverage and group-term life insurance coverage, and on the
cost or coverage change rules in the existing proposed regulations
(at �1.125-2, Q&A-6(b)) with respect to all types of qualified
benefits.

Special Analyses

It has been determined that this notice of proposed rulemaking 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) do not apply to these
regulations, and because the regulations do 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 proposed regulations will be submitted
to the Chief Counsel for Advocacy of the Small Business
Administration for comment on their impact on small business.

Comments and Public Hearing

Before these proposed regulations are adopted as final regulations,
consideration will be given to any written and electronic comments
(a signed original and eight (8) copies) that are submitted timely
to the IRS. The IRS and Treasury specifically request comments on
the clarity of the proposed regulations and how they may be made
easier to understand. All comments will be available for public
inspection and copying. A public hearing will be scheduled if
requested in writing by any person that timely submits written
comments. If a public hearing is scheduled, notice of the date,
time, and place for the hearing will be published in the Federal
Register .

Drafting Information

The principal authors of these proposed 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.

Partial Withdrawal of Notice of Proposed Rulemaking

Under the authority of 26 U.S.C. 7805, �1.125 Q&A-6(c) and (d) in
the notice of proposed rulemaking that was published on March 7,
1989 (54 FR 9460) is withdrawn.

Amendments to Previously Proposed Rules

The proposed rules published on May 7, 1984 (49 FR 19321) and March
7, 1989 (54 FR 9460), and amended on November 7, 1997 (62 FR 60196),
are amended as set forth below.

Proposed Amendments to the Regulations

Accordingly, 26 CFR part 1 is proposed to be 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. In �1.125-1, as proposed to be added on May 7, 1984 (49 FR
19322), in Q&A-8, Q-8 is republished and A-8 is amended by adding
two sentences at the end of

the answer to read as follows:

�1.125-1 Questions and answers relating to cafeteria plans.

* * * * *

Q-8: What requirements apply to participants' elections under a
cafeteria plan?

A-8: * * * For benefit elections relating to accident or health
plans and group-term life insurance coverage, a cafeteria plan may
permit a participant to revoke a benefit.12 election after the
period of coverage has commenced and to make a new election with
respect to the remainder of the period of coverage under the rules
set forth in �1.125-4 pertaining to permitted election changes. For
additional rules governing benefit elections, see �1.125-4.

* * * * *

Par. 3. In �1.125-2, as proposed to be added on March 7, 1989 (54 FR
9500) and amended November 7, 1997 (62 FR 60197), in Q&A-6, Q-6 is
republished and A-6 is amended by:

1. Adding a sentence at the end of paragraph (b)(2).

2. Revising the last sentence of paragraph (c).

3. Revising the last sentence of paragraph (d).

The additions and revisions read as follows: �1.125-2 Miscellaneous
cafeteria plan questions and answers.

* * * * *

Q-6: In what circumstance may participants revoke existing elections
and make new elections under a cafeteria plan?

A-6: * * *

(b) * * *

(2) * * * For additional rules governing cafeteria plan election
changes in connection with a significant cost or coverage change,
see �1.125-4.

(c) Certain changes in family status. *** For additional rules
governing cafeteria plan election changes in connection with certain
changes in status, see �1.125-4.

(d) Separation from service. ***For additional rules governing
cafeteria plan election changes in connection with an employee's
separation from service, see �1.125- 4.

* * * * *

Par.4. �1.125-4 is amended as follows:

1. Paragraph (c) is amended as follows:

a. Revising paragraph (c)(1)(iii).

b. Adding paragraph (c)(2)(vi).

c. Revising paragraph (c)(3)(ii).

d. Adding paragraphs (c)(4)Example 3(iii) and (c)(4)Example 9.

2. Revising paragraph (f).

3. Revising paragraph (g).

4. Revising paragraph (i)(3).

The additions and revisions read as follows: �1.125-4 Permitted
election changes.

* * * * *

(c) * * * (1) * * *

(iii) Application to other qualified benefits. This paragraph (c)
applies to plans providing qualified benefits other than those
listed in paragraph (c)(1)(ii) of this section.

(2) * * *

(vi) Adoption assistance. For purposes of adoption assistance
provided through a cafeteria plan, the commencement or termination
of an adoption proceeding.

(3) * * *

(ii) Application to other qualified benefits. An election change
satisfies the requirements of this paragraph (c)(3) with respect to
other qualified benefits 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. An election change also satisfies
the requirements of this paragraph (c)(3) if the election change is
on account of and corresponds with a change in status that affects
expenses described in section 129 (including employment-related
expenses as defined in section 21(b)(2)) with respect to dependent
care assistance, or expenses described in section 137 (including
qualified adoption expenses as defined in section 137(d)) with
respect to adoption assistance.

* * * * *

(4) * * *

Example 3. * * *

(iii) In addition, under paragraph (f)(4) of this section, if F
makes an election change to cover G under F's employer's plan, then
E may make a corresponding change to elect employee-only coverage
under P's cafeteria plan.

* * * * *

Example 9. (i) Employee A has one child, B. Employee A's employer,
X, maintains a calendar year cafeteria plan that allows employees to
elect coverage under a dependent care FSA. Prior to the beginning of
the calendar year, A elects salary reduction contributions of $4,000
during the year to fund coverage under the dependent care FSA for up
to $4,000 of reimbursements for the year. During the year, B reaches
the age of 13, and A wants to cancel coverage under the dependent
care FSA.

(ii) When B turns 13, B ceases to satisfy the definition of
"qualifying individual" under section 21(b)(1) of the Internal
Revenue Code. Accordingly, B's attainment of age 13 is a change in
status under paragraph (c)(2)(iv) of this section that affects A's
employment-related expenses as defined in section 21(b)(2).
Therefore, A may make a corresponding change under X's cafeteria
plan to cancel coverage under the dependent care FSA.

* * * * *

(f) Significant cost or coverage changes -- (1) In general.
Paragraphs (f)(2) through (5) of this section set forth rules for
election changes as a result of changes in cost or coverage. This
paragraph (f) does not apply to an election change with respect to a
health FSA (or on account of a change in cost or coverage under a
health FSA).

(2) Cost changes - - (i) Automatic changes. If the cost of a
qualified benefits plan increases (or decreases) during a period of
coverage and, under the terms of the plan, employees are required to
make a corresponding change in their payments, the cafeteria plan
may, on a reasonable and consistent basis, automatically make a
prospective increase (or decrease) in affected employees' elective
contributions for the plan.

(ii) Significant cost increases. If the cost of a benefit package
option (as defined in paragraph (i)(2) of this section)
significantly increases during a period of coverage, the cafeteria
plan may permit employees either to make a corresponding prospective
increase in their payments, or to revoke their elections and, in
lieu thereof, to receive on a prospective basis coverage under
another benefit package option providing similar coverage. For
example, if the cost of an indemnity option under an accident or
health plan significantly increases during a period of coverage,
employees who are covered by the indemnity option may make a
corresponding prospective increase in their payments.16 or may
instead elect to revoke their election for the indemnity option and,
in lieu thereof, elect coverage under an HMO option.

(iii) Application to dependent care. This paragraph (f)(2) applies
in the case of a dependent care assistance plan only if the cost
change is imposed by a dependent care provider who is not a relative
of the employee. For this purpose, a relative is an individual who
is related as described in section 152(a)(1) through (8),
incorporating the rules of section 152(b)(1) and (2).

(3) Coverage changes - - (i) Significant curtailment. If the
coverage under a plan is significantly curtailed or ceases during a
period of coverage, the cafeteria plan may permit affected employees
to revoke their elections under the plan. In that case, each
affected employee may make a new election on a prospective basis for
coverage under another benefit package option providing similar
coverage. Coverage under an accident or health plan is significantly
curtailed only if there is an overall reduction in coverage provided
to participants under the plan so as to constitute reduced coverage
to participants generally.

(ii) Addition (or elimination) of benefit package option providing
similar coverage. If during a period of coverage a plan adds a new
benefit package option or other coverage option (or eliminates an
existing benefit package option or other coverage option) the
cafeteria plan may permit affected employees to elect the newly-
added option (or elect another option if an option has been
eliminated) prospectively on a pre-tax basis and make corresponding
election changes with respect to other benefit package options
providing similar coverage.

(4) Change in coverage of spouse or dependent under other employer's
plan. A cafeteria plan may permit an employee to make a prospective
election change that is on account of and corresponds with a change
made under the plan of the spouse's, former spouse's or dependent's
employer if -

(i) A cafeteria plan or qualified benefits plan of the spouse's,
former spouse's, or dependent's employer permits participants to
make an election change that would be permitted under paragraphs (b)
through (g) of this section (disregarding this paragraph

(f)(4)); or

(ii) The cafeteria plan permits participants to make an election for
a period of coverage that is different from the period of coverage
under the cafeteria plan or qualified benefits plan of the spouse's,
former spouse's, or dependent's employer.

(5) Examples. The following examples illustrate the application of
this paragraph

(f): Example 1. (i) A calendar year cafeteria plan is maintained
pursuant to a collective bargaining agreement for the benefit of
Employer M's employees. The cafeteria plan offers various benefits,
including indemnity health insurance and a health FSA. As a result
of mid-year negotiations, premiums for the indemnity health
insurance are reduced in the middle of the year, insurance co-
payments for office visits are reduced under the indemnity plan, and
an HMO option is added.

(ii) Under these facts, the reduction in health insurance premiums
is a reduction in cost. Accordingly, under paragraph (f)(2)(i) of
this section, the cafeteria plan may automatically decrease the
amount of salary reduction contributions of affected participants by
an amount that corresponds to the premium change. However, the plan
may not permit employees to change their health FSA elections to
reflect the mid-year change in copayments under the indemnity plan.

(iii) Also, the addition of the HMO option is an addition of a
benefit package option. Accordingly, under paragraph (f)(3)(ii) of
this section, the cafeteria plan may permit affected participants to
make an election change to elect the new HMO option. However, the
plan may not permit employees to change their health FSA elections
to reflect differences in copayments under the HMO option.

Example 2. (i) Employer N sponsors a group health plan under which
employees may elect either employee-only coverage or family health
coverage. The 12-month period of coverage under N's cafeteria plan
begins January 1, 2001. N's employee, A, is married to B. Employee A
elects employee-only coverage under N's plan. B's employer, O,
offers health coverage to O's employees under its group health plan
under which employees may elect either employee-only coverage or
family coverage. O's plan has a 12-month period of coverage
beginning September 1, 2001. B maintains individual coverage under
O's plan at the time A elects coverage under N's plan, and wants to
elect no coverage for the plan year beginning on September 1, 2001,
which is the next period of coverage under O's group health plan.

(ii) Under paragraph (f)(4)(ii) of this section, N's cafeteria plan
may permit A to change A's election prospectively to family coverage
under that plan effective September 1, 2001 if B actually elects no
coverage under O's group health plan for the plan year beginning on
September 1, 2001.

Example 3. (i) Employer P sponsors a calendar year cafeteria plan
under which employees may elect either employee-only or family
health coverage. Before the beginning of the year, P's employee, C,
elects family coverage under P's cafeteria plan. C also elects
coverage under the health FSA for up to $200 of reimbursements for
the year to be funded by salary reduction contributions of $200
during the year. C is married to D, who is employed by Employer Q. Q
does not maintain a cafeteria plan, but does maintain a group health
plan providing its employees with employee-only coverage. During the
calendar year, Q adds family coverage as an option under its health
plan. D elects family coverage under Q's plan, and C wants to revoke
C's election for health coverage and elect no health coverage under
P's cafeteria plan for the remainder of the year.

(ii) Q's addition of family coverage as an option under its health
plan constitutes a new coverage option described in paragraph (f)(3)
(ii) of this section. Accordingly, pursuant to paragraph (f)(4)(i)
of this section, P's cafeteria plan may permit C to revoke C's
health coverage election if D actually elects family health coverage
under Q's group health plan. Employer P's plan may not permit C to
change C's health FSA election. Example 4. (i) Employer R maintains
a cafeteria plan under which employees may elect accident or health
coverage under either an indemnity plan or an HMO. Before the
beginning of the year, R's employee, E elects coverage under the HMO
at a premium cost of $100 per month. During the year, E decides to
switch to the indemnity plan, which charges a premium of $140 per
month.

(ii) E's change from the HMO to indemnity plan is not a change in
cost or coverage under this paragraph (f), and none of the other
election change rules under paragraphs (b) through (e) of this
section apply. While R's health plan may permit E to make the change
from the HMO to the indemnity plan, R's cafeteria plan may not
permit E to make an election change to reflect the increased
premium. Accordingly, if E switches from the HMO to the indemnity
plan, E may pay the $40 per month additional cost on an after-tax
basis.

Example 5. (i) Employee A is married to Employee B and they have one
child, C. Employee A's employer, M, maintains a calendar year
cafeteria plan that allows employees to elect coverage under a
dependent care FSA. Child C attends X's on site child care center at
an annual cost of $3,000. Prior to the beginning of the year, A
elects salary reduction contributions of $3,000 during the year to
fund coverage under the dependent care FSA for up to $3,000 of
reimbursements for the year. Employee A now wants to revoke A's
election of coverage under the dependent care FSA, because A has
found a new child care provider.

(ii) The availability of dependent care services from the new child
care provider (whether the new provider is a household employee or
family member of A or B or a person who is independent of A and B)
is a significant change in coverage similar to a benefit package
option becoming available. Thus, M's cafeteria plan may permit A to
elect to revoke A's previous election of coverage under the
dependent care FSA, and make a corresponding new election to reflect
the cost of the new child care provider. Example 6. (i) Employee D
is married to Employee E and they have one child, F.

Employee D's employer, N, maintains a calendar year cafeteria plan
that allows employees to elect coverage under a dependent care FSA.
Child F is cared for by Y, D's household employee, who provides
child care services five days a week from 9 a.m. to 6 p.m. at an
annual cost in excess of $5,000. Prior to the beginning of the year,
D elects salary reduction contributions of $5,000 during the year to
fund coverage under the dependent care FSA for up to $5,000 of
reimbursements for the year. During the year, F begins school and,
as a result, Y's regular hours of work are changed to five days a
week from 3 p.m. to 6 p.m. Employee D now wants to revoke D's
election under the dependent care FSA, and make a new election under
the dependent care FSA to an annual cost of $4,000 to reflect a
reduced cost of child care due to Y's reduced hours.

(ii) The change in the number of hours of work performed by Y is a
change in coverage. Thus, N's cafeteria plan may permit D to reduce
D's previous election under the dependent care FSA to $4,000.

Example 7. (i) Employee G is married to Employee H and they have one
child, J. Employee G's employer, O, maintains a calendar year
cafeteria plan that allows employees to elect coverage under a
dependent care FSA. Child J is cared for by Z, G's household
employee, who is not a relative of G and who provides child care
services at an annual cost of $4,000. Prior to the beginning of the
year, G elects salary reduction contributions of $4,000 during the
year to fund coverage under the dependent care FSA for up to $4,000
of reimbursements for the year. During the year, G raises Z's
salary. Employee G now wants to revoke G's election under the
dependent care FSA, and make a new election under the dependent care
FSA to an annual amount of $4,500 to reflect the raise.

(ii) The raise in Z's salary is a significant increase in cost under
paragraph (f)(2)(ii) of this section, and an increase in election to
reflect the raise corresponds with that change in status. Thus, O's
cafeteria plan may permit G to elect to increase G's election under
the dependent care FSA.

(g) Special requirements relating to the Family and Medical Leave
Act. [Reserved]

* * * * *

(i) * * *

(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, and, for purposes of dependent care assistance
provided through a cafeteria plan, a dependent means a qualifying
individual (as defined in section 21(b)(1)) with respect to the
employee.

* * * * *

Robert E. Wenzel
Deputy Commissioner of Internal Revenue

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