# Prop. Treas. Reg. § 1.125-1: Cafeteria plans; general rules. Proposed regulation, not in force. REG-117162-99, 72 FR 43938, published 2007-08-06 . Interprets 26 U.S.C. § 125. Par. 2 . Sections 1.125-0, 1.125-1 and 1.125-2 are added to read as follows: (a) Definitions. (b) General rules. (c) Written plan requirements. (d) Plan year requirements. (e) Grace period. (f) Run-out period. (g) Employee for purpose of Section 125. (h) After-tax employee contributions. (i) Prohibited taxable benefits. (j) Coordination with other rules. (k) Group-term life insurance. (l) COBRA premiums. (m) Payment or reimbursement of employees' individual accident and health insurance premiums. (n) Section 105 rules for accident and health plan offered through a cafeteria plan. (o) Prohibition against deferred compensation. (p) Benefits relating to more than one year. (q) Nonqualified benefits. (r) Employer contributions to a cafeteria plan. (s) Effective/applicability date. (a) Definitions. The definitions set forth in this paragraph (a) apply for purposes of section 125 and the regulations. (1) The term cafeteria plan means a separate written plan that complies with the requirements of section 125 and the regulations, that is maintained by an employer for the benefit of its employees and that is operated in compliance with the requirements of section 125 and the regulations. All participants in a cafeteria plan must be employees. A cafeteria plan must offer at least one permitted taxable benefit (as defined in paragraph (a)(2) of this section) and at least one qualified benefit (as defined in paragraph (a)(3) of this section). A cafeteria plan must not provide for deferral of compensation (except as specifically permitted in paragraph (o) of this section). (2) The term permitted taxable benefit means cash and certain other taxable benefits treated as cash for purposes of section 125. For purposes of section 125, cash means cash compensation (including salary reduction), payments for annual leave, sick leave, or other paid time off and severance pay. A distribution from a trust described in section 401(a) is not cash for purposes of section 125. Other taxable benefits treated as cash for purposes of section 125 are: (i) Property; (ii) Benefits attributable to employer contributions that are currently taxable to the employee upon receipt by the employee; and (iii) Benefits purchased with after-tax employee contributions, as described in paragraph (h) of this section. (3) Qualified benefit. Except as otherwise provided in section 125(f) and paragraph (q) of this section, the term qualified benefit means any benefit attributable to employer contributions to the extent that such benefit is not currently taxable to the employee by reason of an express provision of the Internal Revenue Code (Code) and which does not defer compensation (except as provided in paragraph (o) of this section). The following benefits are qualified benefits that may be offered under a cafeteria plan and are excludible from employees' gross income when provided in accordance with the applicable provisions of the Code— (A) Group-term life insurance on the life of an employee in an amount that is less than or equal to the $50,000 excludible from gross income under section 79(a), but not combined with any permanent benefit within the meaning of § 1.79-0; (B) An accident and health plan excludible from gross income under section 105 or 106, including self-insured medical reimbursement plans (such as health FSAs described in § 1.125-5); (C) Premiums for COBRA continuation coverage (if excludible under section 106) under the accident and health plan of the employer sponsoring the cafeteria plan or premiums for COBRA continuation coverage of an employee of the employer sponsoring the cafeteria plan under an accident and health plan sponsored by a different employer; (D) An accidental death and dismemberment insurance policy (section 106); (E) Long-term or short-term disability coverage (section 106); (F) Dependent care assistance program (section 129); (G) Adoption assistance (section 137); (H) A qualified cash or deferred arrangement that is part of a profit-sharing plan or stock bonus plan, as described in paragraph (o)(3) of this section (section 401(k)); (I) Certain plans maintained by educational organizations (section 125(d)(2)(C) and paragraph (o)(3)(iii) of this section); and (J) Contributions to Health Savings Accounts (HSAs) (sections 223 and 125(d)(2)(D)). (4) Dependent. The term dependent generally means a dependent as defined in section 152. However, the definition of dependent is modified to conform with the underlying Code section for the qualified benefit. For example, for purposes of a benefit under section 105, the term dependent means a dependent as defined in section 152, determined without regard to section 152(b)(1), (b)(2) or (d)(1)(B). (5) Premium-only-plan. A premium-only-plan is a cafeteria plan that offers as its sole benefit an election between cash (for example, salary) and payment of the employee share of the employer-provided accident and health insurance premium (excludible from the employee's gross income under section 106). (b) General rules —(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. (2) Nondiscrimination rules for qualified benefits. Accident and health plan coverage, group-term life insurance coverage, and benefits under a dependent care assistance program or adoption assistance program do not fail to be qualified benefits under a cafeteria plan merely because they are includible in gross income because of applicable nondiscrimination requirements (for example, sections 79(d), 105(h),129(d), 137(c)(2)). See also §§ 1.105-11(k) and 1.125-7. (3) Examples. The following examples illustrate the rules of paragraph (b)(1) of this section. Example 1. Distributions from qualified pension plan used for health insurance premiums. (i) Employer A maintains a qualified section 401(a) retirement plan for employees. Employer A also provides accident and health insurance (as described in section 106) for employees and former employees, their spouses and dependents. The health insurance premiums are partially paid through a cafeteria plan. None of Employer A's employees are public safety officers. Employer A's health plan allows former employees to elect to have distributions from the qualified retirement plan applied to pay for the health insurance premiums through the cafeteria plan. (ii) Amounts distributed from the qualified retirement plan which the former employees elect to have applied to pay health insurance premiums through the cafeteria plan are includible in their gross income. The same result occurs if distributions from the qualified retirement plan are applied directly to reimburse section 213(d) medical care expenses incurred by a former employee or his or her spouse or dependents. These distributions are includible in their income, and are not cash for purposes of section 125. The plan is not a cafeteria plan with respect to former employees. Example 2. Severance pay used to pay COBRA premiums. Employer B maintains a cafeteria plan, which offers employees an election between cash and employer-provided accident and health insurance (excludible from employees' gross income under section 106). Employer B pays terminating employees severance pay. The cafeteria plan also allows a terminating employee to elect between receiving severance pay and using the severance pay to pay the COBRA premiums for the accident and health insurance. These provisions in the cafeteria plan are consistent with the requirements in section 125. (4) Election by participants —(i) In general. A cafeteria plan must offer participants the opportunity to elect between at least one permitted taxable benefit and at least one qualified benefit. For example, if employees are given the opportunity to elect only among two or more nontaxable benefits, the plan is not a cafeteria plan. Similarly, a plan that only offers the election among salary, permitted taxable benefits, paid time off or other taxable benefits is not a cafeteria plan. See section 125(a), (d). See § 1.125-2 for rules on elections. (ii) Premium-only-plan. A cafeteria plan may be a premium-only-plan. (iii) Examples. The following examples illustrate the rules of paragraph (b)(4)(i) of this section. Example 1. No election. Employer C covers all its employees under its accident and health plan (excludible from employees' gross income under section 106). Coverage is mandatory (that is, employees have no election between cash and the Employer C's accident and health plan). This plan is not a cafeteria plan, because the plan offers employees no election between taxable and nontaxable benefits. The accident and health coverage is excludible from employees' gross income. Example 2. Election between cash and at least one qualified benefit. Employer D offers its employees a plan with an election between cash and an employer-provided accident and health plan (excludible from employees' gross income under section 106). If the plan also satisfies all the other requirements of section 125, the plan is a cafeteria plan because it offers an election between at least one taxable benefit and at least one nontaxable qualified benefit. Example 3. Election between employer flex-credits and qualified benefits. Employer E offers its employees an election between an employer flex-credit (as defined in paragraph (b) in § 1.125-5) and qualified benefits. If an employee does not elect to apply the entire employer flex-credit to qualified benefits, the employee will receive no cash or other taxable benefit for the unused employer flex-credit. The plan is not a cafeteria plan because it does not offer an election between at least one taxable benefit and at least one nontaxable qualified benefit. Example 4. No election between cash and qualified benefits for certain employees. (i) Employer F maintains a calendar year plan offering employer-provided accident and health insurance coverage which includes employee-only and family coverage options. (ii) The plan provides for an automatic enrollment process when a new employee is hired, or during the annual election period under the plan: only employees who certify that they have other health coverage are permitted to elect to receive cash. Employees who cannot certify are covered by the accident and health insurance on a mandatory basis. Employer F does not otherwise request or collect information from employees regarding other health coverage as part of the enrollment process. If the employee has a spouse or child, the employee can elect between cash and family coverage. (iii) When an employee is hired, the employee receives a notice explaining the plan's automatic enrollment process. The notice includes the salary reduction amounts for employee-only coverage and family coverage, procedures for certifying whether the employee has other health coverage, elections for family coverage, information on the time by which a certification or election must be made, and the period for which a certification or election will be effective. The notice is also given to each current employee before the beginning of each plan year, (except that the notice for a current employee includes a description of the employee's existing coverage, if any). (iv) For a new employee, an election to receive cash or to have family coverage is effective if made when the employee is hired. For a current employee, an election is effective if made prior to the start of each calendar year or under any other circumstances permitted under § 1.125-4. An election for any prior year carries over to the next succeeding plan year unless changed. Certification that the employee has other health coverage must be made annually. (v) Contributions used to purchase employer-provided accident and health coverage under section 125 are not includible in an employee's gross income if the employee can elect cash. Section 125 does not apply to the employee-only coverage of an employee who cannot certify that he or she has other health coverage and, therefore, does not have the ability to elect cash in lieu of health coverage. (5) No deferred compensation. Except as provided in paragraph (o) of this section, in order for a plan to be a cafeteria plan, the qualified benefits and the permitted taxable benefits offered through the cafeteria plan must not defer compensation. For example, a cafeteria plan may not provide for retirement health benefits for current employees beyond the current plan year or group-term life insurance with a permanent benefit, as defined under § 1.79-0. (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. (2) Additional requirements under sections 105(h), 129, and 137. A written plan is required for self-insured medical reimbursement plans (§ 1.105-11(b)(1)(i)), dependent care assistance programs (section 129(d)(1)), and adoption assistance (section 137(c)). Any of these plans or programs offered through a cafeteria plan that satisfies the written plan requirement in this paragraph (c) for the benefits under these plans and programs also satisfies the written plan requirements in § 1.105-11(b)(1)(i), section 129(d)(1), and section 137(c) (whichever is applicable). Alternatively, a self-insured medical reimbursement plan, a dependent care assistance program, or an adoption assistance program is permitted to satisfy the requirements in § 1.105-11(b)(1)(i), section 129(d)(1), or section 137(c) (whichever is applicable) through a separate written plan, and not as part of the written cafeteria plan. (3) Additional requirements under section 401(k). See § 1.401(k)-1(e)(7) for additional requirements that must be satisfied in the written plan if the plan offers deferrals into a section 401(k) plan. (4) Cross-reference allowed. In describing the benefits available through the cafeteria plan, the written cafeteria plan need not be self-contained. For example, the written cafeteria plan may incorporate by reference benefits offered through other separate written plans, such as a section 401(k) plan, or coverage under a dependent care assistance program (section 129), without describing in full the benefits established through these other plans. But, for example, if the cafeteria plan offers different maximum levels of coverage for dependent care assistance programs, the descriptions in the separate written plan must specify the available maximums. (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. (7) Operational failure — (i) In general. If the cafeteria plan fails to operate according to its written plan or otherwise fails to operate in compliance with section 125 and the regulations, the plan is not a cafeteria plan and employees' elections between taxable and nontaxable benefits result in gross income to the employees. (ii) Failure to operate according to written cafeteria plan or section 125. Examples of failures resulting in section 125 not applying to a plan include the following— (A) Paying or reimbursing expenses for qualified benefits incurred before the later of the adoption date or effective date of the cafeteria plan, before the beginning of a period of coverage or before the later of the date of adoption or effective date of a plan amendment adding a new benefit; (B) Offering benefits other than permitted taxable benefits and qualified benefits; (C) Operating to defer compensation (except as permitted in paragraph (o) of this section); (D) Failing to comply with the uniform coverage rule in paragraph (d) in § 1.125-5; (E) Failing to comply with the use-or-lose rule in paragraph (c) in § 1.125-5; (F) Allowing employees to revoke elections or make new elections, except as provided in § 1.125-4 and paragraph (a) in § 1.125-2; (G) Failing to comply with the substantiation requirements of § 1.125-6; (H) Paying or reimbursing expenses in an FSA other than expenses expressly permitted in paragraph (h) in § 1.125-5; (I) Allocating experience gains other than as expressly permitted in paragraph (o) in § 1.125-5; (J) Failing to comply with the grace period rules in paragraph (e) of this section; or (K) Failing to comply with the qualified HSA distribution rules in paragraph (n) in § 1.125-5. (d) Plan year requirements —(1) Twelve consecutive months. The plan year must be specified in the cafeteria plan. The plan year of a cafeteria plan must be twelve consecutive months, unless a short plan year is allowed under this paragraph (d). A plan year is permitted to begin on any day of any calendar month and must end on the preceding day in the immediately following year (for example, a plan year that begins on October 15, 2007, must end on October 14, 2008). A calendar year plan year is a period of twelve consecutive months beginning on January 1 and ending on December 31 of the same calendar year. A plan year specified in the cafeteria plan is effective for the first plan year of a cafeteria plan and for all subsequent plan years, unless changed as provided in paragraph (d)(2) of this section. (2) Changing plan year. The plan year is permitted to be changed only for a valid business purpose. A change in the plan year is not permitted if a principal purpose of the change in plan year is to circumvent the rules of section 125 or these regulations. If a change in plan year does not satisfy this subparagraph, the attempt to change the plan year is ineffective and the plan year of the cafeteria plan remains the same. (3) Short plan year. A short plan year of less than twelve consecutive months is permitted for a valid business purpose. (4) Examples. The following examples illustrate the rules in paragraph (d) of this section: Example 1. Employer with calendar year. Employer G, with a calendar taxable year, first establishes a cafeteria plan effective July 1, 2009. The cafeteria plan specifies a calendar plan year. The first cafeteria plan year is the period beginning on July 1, 2009, and ending on December 31, 2009. Employer G has a business purpose for a short first cafeteria plan year. Example 2. Employer changes insurance carrier. Employer H establishes a cafeteria plan effective January 1, 2009, with a calendar year plan year. The cafeteria plan offers an accident and health plan through Insurer X. In March 2010, Employer H contracts to provide accident and health insurance through another insurance company, Y. Y's accident and health insurance is offered on a July 1-June 30 benefit year. Effective July 1, 2010, Employer H amends the plan to change to a July 1-June 30 plan year. Employer H has a business purpose for changing the cafeteria plan year and for the short plan year ending June 30, 2010. (5) Significance of plan year. The plan year generally is the coverage period for benefits provided through the cafeteria plan to which annual elections for these benefits apply. Benefits elected pursuant to the employee's election for a plan year generally may not be carried forward to subsequent plan years. However, see the grace period rule in paragraph (e) of this section. (e) Grace period —(1) In general. A cafeteria plan may, at the employer's option, include a grace period of up to the fifteenth day of the third month immediately following the end of each plan year. If a cafeteria plan provides for a grace period, an employee who has unused benefits or contributions relating to a qualified benefit (for example, health flexible spending arrangement (health FSA) or dependent care assistance) from the immediately preceding plan year, and who incurs expenses for that same qualified benefit during the grace period, may be paid or reimbursed for those expenses from the unused benefits or contributions as if the expenses had been incurred in the immediately preceding plan year. A grace period is available for all qualified benefits described in paragraph (a)(3) of this section, except that the grace period does not apply to paid time off and elective contributions under a section 401(k) plan. The effect of the grace period is that the employee may have as long as 14 months and 15 days (that is, the 12 months in the current cafeteria plan year plus the grace period) to use the benefits or contributions for a plan year before those amounts are forfeited under the use-or-lose rule in paragraph (c) in § 1.125-5. If the grace period is added to a cafeteria plan through an amendment, all requirements in paragraph (c) of this section must be satisfied. (2) Grace period optional features. A grace period provision may contain any or all of the following— (i) The grace period may apply to some qualified benefits described in paragraph (a)(3) of this section, but not to others; (ii) The grace period provision may limit the amount of unused benefits or contributions available during the grace period. The limit must be uniform and apply to all participants. However, the limit must not be based on a percentage of the amount of the unused benefits or contributions remaining at the end of the immediately prior plan year; (iii) The last day of the grace period may be sooner than the fifteenth day of the third month immediately following the end of the plan year (that is, the grace period may be shorter than two and one half months); (iv) The grace period provision is permitted to treat expenses for qualified benefits incurred during the grace period either as expenses incurred during the immediately preceding plan year or as expenses incurred during the current plan year (for example, the plan may first apply the unused contributions or benefits from the immediately preceding year to pay or reimburse grace period expenses and then, when the unused contributions and benefits from the prior year are exhausted, the grace period expenses may be paid from current year contributions and benefits.); and (v) The grace period provision may permit the employer to defer the allocation of expenses described in paragraph (e)(2)(iv) of this section until after the end of the grace period. (3) Grace period requirements. A grace period must satisfy the requirements in paragraph (c) of this section and all of the following requirements: (i) The grace period provisions in the cafeteria plan (including optional provisions in paragraph (e)(2) of this section) must apply uniformly to all participants in the cafeteria plan, determined as of the last day of the plan year. Participants in the cafeteria plan through COBRA and participants who were participants as of the last day of the plan year but terminate during the grace period are participants for purposes of the grace period. See § 54.4980B-2, Q & A-8 of this chapter; (ii) The grace period provision in the cafeteria plan must state that unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to the same qualified benefit. For example, unused amounts elected to pay or reimburse medical expenses in a health FSA may not be used to pay or reimburse dependent care expenses incurred during the grace period; and (iii) The grace period provision in the cafeteria plan must state that to the extent any unused benefits or contributions from the immediately preceding plan year exceed the expenses for the qualified benefit incurred during the grace period, those remaining unused benefits or contributions may not be carried forward to any subsequent period (including any subsequent plan year), cannot be cashed-out and must be forfeited under the use-or-lose rule. See paragraph (c) in § 1.125-5 (4) Examples. The following examples illustrate the rules in this paragraph (e). Example 1. Expenses incurred during grace period and immediately following plan year. (i) Employer I's calendar year cafeteria plan includes a grace period allowing all participants to apply unused benefits or contributions remaining at the end of the plan year to qualified benefits incurred during the grace period immediately following that plan year. The grace period for the plan year ending December 31, 2009, ends on March 15, 2010. (ii) Employee X timely elected salary reduction of $1,000 for a health FSA for the plan year ending December 31, 2009. As of December 31, 2009, X has $200 remaining unused in his health FSA. X timely elected salary reduction for a health FSA of $1,500 for the plan year ending December 31, 2010. (iii) During the grace period from January 1 through March 15, 2010, X incurs $300 of unreimbursed medical expenses (as defined in section 213(d)). The unused $200 from the plan year ending December 31, 2009, is applied to pay or reimburse $200 of X's $300 of medical expenses incurred during the grace period. Therefore, as of March 16, 2010, X has no unused benefits or contributions remaining for the plan year ending December 31, 2009. (iv) The remaining $100 of medical expenses incurred between January 1 and March 15, 2010, is paid or reimbursed from X's health FSA for the plan year ending December 31, 2010. As of March 16, 2010, X has $1,400 remaining in the health FSA for the plan year ending December 31, 2010. Example 2. Unused benefits exceed expenses incurred during grace period. Same facts as Example 1, except that X incurs $150 of section 213(d) medical expenses during the grace period (January 1 through March 15, 2010). As of March 16, 2010, X has $50 of unused benefits or contributions remaining for the plan year ending December 31, 2009. The unused $50 cannot be cashed-out, converted to any other taxable or nontaxable benefit, or used in any other plan year (including the plan year ending December 31, 2009). The unused $50 is subject to the use-or-lose rule in paragraph (c) in § 1.125-5 and is forfeited. As of March 16, 2010, X has the entire $1,500 elected in the health FSA for the plan year ending December 31, 2010. Example 3. Terminated participants. (i) Employer J's cafeteria plan includes a grace period allowing all participants to apply unused benefits or contributions remaining at the end of the plan year to qualified benefits incurred during the grace period immediately following that plan year. For the plan year ending on December 31, 2009, the grace period ends March 15, 2010. (ii) Employees A, B, C, and D each timely elected $1,200 salary reduction for a health FSA for the plan year ending December 31, 2009. Employees A and B terminated employment on September 15, 2009. Each has $500 of unused benefits or contributions in the health FSA. (iii) Employee A elected COBRA for the health FSA. Employee A is a participant in the cafeteria plan as of December 31, 2009, the last day of the 2009 plan year. Employee A has $500 of unused benefits or contributions available during the grace period for the 2009 plan year (ending March 15, 2010). (iv) Employee B did not elect COBRA for the health FSA. Employee B is not a participant in the cafeteria plan as of December 31, 2009. The grace period does not apply to Employee B. (v) Employee C has $500 of unused benefits in his health FSA as of December 31, 2009, and terminated employment on January 15, 2010. Employee C is a participant in the cafeteria plan as of December 31, 2009 and has $500 of unused benefits or contributions available during the grace period ending March 15, 2010, even though he terminated employment on January 15, 2010. (vi) Employee D continues to work for Employer H throughout 2009 and 2010, also has $500 of unused benefits or contributions in his health FSA as of December 31, 2009, but made no health FSA election for 2010. Employee D is a participant in the cafeteria plan as of December 31, 2009 and has $500 of unused benefits or contributions available during the grace period ending March 15, 2010, even though he is not a participant in a health FSA for the 2010 plan year. (f) Run-out period. A cafeteria plan is permitted to contain a run-out period as designated by the employer. A run-out period is a period after the end of the plan year (or grace period) during which a participant can submit a claim for reimbursement for a qualified benefit incurred during the plan year (or grace period). Thus, a plan is also permitted to provide a deadline on or after the end of the plan year (or grace period) for submitting a claim for reimbursement for the plan year. Any run-out period must be provided on a uniform and consistent basis with respect to all participants. (g) Employee for purposes of section 125 —(1) Current employees, former employees. The term employee includes any current or former employee (including any laid-off employee or retired employee) of the employer. See paragraph (g)(3) of this section concerning limits on participation by former employees. Specifically, the term employee includes the following— (i) Common law employee; (ii) Leased employee described in section 414(n); (iii) Full-time life insurance salesman (as defined in section 7701(a)(20)); and (iv) A current employee or former employee described in paragraphs (g)(1)(i) through (iii) of this section. (2) Self-employed individual not an employee —(i) In general. The term employee does not include a self-employed individual or a 2-percent shareholder of an S corporation, as defined in paragraph (g)(2)(ii) of this subsection. For example, a sole proprietor, a partner in a partnership, or a director solely serving on a corporation's board of directors (and not otherwise providing services to the corporation as an employee) is not an employee for purposes of section 125, and thus is not permitted to participate in a cafeteria plan. However, a sole proprietor may sponsor a cafeteria plan covering the sole proprietor's employees (but not the sole proprietor). Similarly, a partnership or S corporation may sponsor a cafeteria plan covering employees (but not a partner or 2-percent shareholder of an S corporation). (ii) Two percent shareholder of an S corporation. A 2-percent shareholder of an S corporation has the meaning set forth in section 1372(b). (iii) Certain dual status individuals. If an individual is an employee of an employer and also provides services to that employer as an independent contractor or director (for example, an individual is both a director and an employee of a C corp), the individual is eligible to participate in that employer's cafeteria plan solely in his or her capacity as an employee. This rule does not apply to partners or to 2-percent shareholders of an S corporation. (iv) Examples. The following examples illustrate the rules in paragraphs (g)(2)(ii) and (g)(2)(iii) of this section: Example 1. Two-percent shareholders of an S corporation. (i) Employer K, an S corporation, maintains a cafeteria plan for its employees (other than 2-percent shareholders of an S corporation). Employer K's taxable year and the plan year are the calendar year. On January 1, 2009, individual Z owns 5 percent of the outstanding stock in Employer K. Y, who owns no stock in Employer K, is married to Z. Y and Z are employees of Employer K. Z is a 2-percent shareholder in Employer K (as defined in section 1372(b)). Y is also a 2-percent shareholder in Employer K by operation of the attribution rules in section 318(a)(1)(A)(i). (ii) On July 15, 2009, Z sells all his stock in Employer K to an unrelated third party, and ceases to be a 2-percent shareholder. Y and Z continue to work as employees of Employer K during the entire 2009 calendar year. Y and Z are ineligible to participate in Employer K's cafeteria plan for the 2009 plan year. Example 2. Director and employee. T is an employee and also a director of Employer L, a C corp that sponsors a cafeteria plan. The cafeteria plan allows only employees of Employer L to participate in the cafeteria plan. T's annual compensation as an employee is $50,000; T is also paid $3,000 annually in director's fees. T makes a timely election to salary reduce $5,000 from his employee compensation for dependent care benefits. T makes no election with respect to his compensation as a director. T may participate in the cafeteria plan in his capacity as an employee of Employer L. (3) Limits on participation by former employees. Although former employees are treated as employees, a cafeteria plan may not be established or maintained predominantly for the benefit of former employees of the employer. Such a plan is not a cafeteria plan. (4) No participation by the spouse or dependent of an employee —(i) Benefits allowed to participant's spouse or dependents but not participation. The spouse or dependents of employees may not be participants in a cafeteria plan unless they are also employees. However, a cafeteria plan may provide benefits to spouses and dependents of participants. For example, although an employee's spouse may benefit from the employee's election of accident and health insurance coverage or of coverage through a dependent care assistance program, the spouse may not participate in a cafeteria plan (that is, the spouse may not be given the opportunity to elect or purchase benefits offered by the plan). (ii) Certain elections after employee's death. An employee's spouse is not a participant in a cafeteria plan merely because the spouse has the right, upon the death of the employee, to elect among various settlement options or to elect among permissible distribution options with respect to the deceased employee's benefits through a section 401(k) plan, Health Savings Account, or certain group-term life insurance offered through the cafeteria plan. See § 54.4980B-2, Q & A 8 and § 54.4980B-4, Q & A-1 of this chapter on COBRA rights of a participant's spouse or dependents. (5) Employees of certain controlled groups. All employees who are treated as employed by a single employer under section 414(b), (c), (m), or (o) are treated as employed by a single employer for purposes of section 125. Section 125(g)(4); section 414(t). (h) After-tax employee contributions —(1) Certain after-tax employee contributions treated as cash. In addition to the cash benefits described in paragraph (a)(2) of this section, in general, a benefit is treated as cash for purposes of section 125 if the benefit does not defer compensation (except as provided in paragraph (o) of this section) and an employee who receives the benefit purchases such benefit with after-tax employee contributions or is treated, for all purposes under the Code (including, for example, reporting and withholding purposes), as receiving, at the time that the benefit is received, cash compensation equal to the full value of the benefit at that time and then purchasing the benefit with after-tax employee contributions. Thus, for example, long-term disability coverage is treated as cash for purposes of section 125 if the cafeteria plan provides that an employee may purchase the coverage through the cafeteria plan with after-tax employee contributions or provides that the employee receiving such coverage is treated as having received cash compensation equal to the value of the coverage and then as having purchased the coverage with after-tax employee contributions. Also, for example, a cafeteria plan may offer employees the opportunity to purchase, with after-tax employee contributions, group-term life insurance on the life of an employee (providing no permanent benefits), an accident and health plan, or a dependent care assistance program. (2) Accident and health coverage purchased for someone other than the employee's spouse or dependents with after-tax employee contributions. If the requirements of section 106 are satisfied, employer-provided accident and health coverage for an employee and his or her spouse or dependents is excludible from the employee's gross income. The fair market value of coverage for any other individual, provided with respect to the employee, is includible in the employee's gross income. § 1.106-1; § 1.61-21(a)(4), and § 1.61-21(b)(1). A cafeteria plan is permitted to allow employees to elect accident and health coverage for an individual who is not the spouse or dependent of the employee as a taxable benefit. (3) Example. The following example illustrates the rules of this paragraph (h): Example. Accident and health plan coverage for individuals who are not a spouse or dependent of an employee. (i) Employee C participates in Employer M's cafeteria plan. Employee C timely elects salary reduction for employer-provided accident and health coverage for himself and for accident and health coverage for his former spouse. C's former spouse is not C's dependent. A former spouse is not a spouse as defined in section 152. (ii) The fair market value of the coverage for the former spouse is $1,000. Employee C has $1,000 includible in gross income for the accident and health coverage of his former spouse, because the section 106 exclusion applies only to employer-provided accident and health coverage for the employee or the employee's spouse or dependents. (iii) No payments or reimbursements received under the accident and health coverage result in gross income to Employee C or to the former spouse. The result is the same if the $1,000 for coverage of C's former spouse is paid from C's after-tax income outside the cafeteria plan. (i) Prohibited taxable benefits. Any taxable benefit not described in paragraph (a)(2) of this section and not treated as cash for purposes of section 125 in paragraph (h) of this section is not permitted to be included in a cafeteria plan. A plan that offers taxable benefits other than the taxable benefits described in paragraph (a)(2) and (h) of this section is not a cafeteria plan. (j) Coordination with other rules —(1) In general. If a benefit is excludible from an employee's gross income when provided separately, the benefit is excludible from gross income when provided through a cafeteria plan. Thus, a qualified benefit is excludible from gross income if both the rules under section 125 and the specific rules providing for the exclusion of the benefit from gross income are satisfied. For example, if the nondiscrimination rules for specific qualified benefits (for example, sections 79(d), 105(h), 129(d)(2), 137(c)(2)) are not satisfied, those qualified benefits are includible in gross income. Thus, if $50,000 in group-term life insurance is offered through a cafeteria plan, the nondiscrimination rules in section 79(d) must be satisfied in order to exclude the coverage from gross income. (2) Section 125 nondiscrimination rules. Qualified benefits are includible in the gross income of highly compensated participants or key employees if the nondiscrimination rules of section 125 are not satisfied. See § 1.125-7. (3) Taxable benefits. If a benefit that is includible in gross income when offered separately is offered through a cafeteria plan, the benefit continues to be includible in gross income. (k) Group-term life insurance —(1) In general. In addition to offering up to $50,000 in group-term life insurance coverage excludible under section 79(a), a cafeteria plan may offer coverage in excess of that amount. The cost of coverage in excess of $50,000 in group-term life insurance coverage provided under a policy or policies carried directly or indirectly by one or more employers (taking into account all coverage provided both through a cafeteria plan and outside a cafeteria plan) is includible in an employee's gross income. Group-term life insurance combined with permanent benefits, within the meaning of § 1.79-0, is a prohibited benefit in a cafeteria plan. (2) Determining cost of insurance includible in employee's gross income —(i) In general. If the aggregate group-term life insurance coverage on the life of the employee (under policies carried directly or indirectly by the employer) exceeds $50,000, all or a portion of the insurance is provided through a cafeteria plan, and the group-term life insurance is provided through a plan that meets the nondiscrimination rules of section 79(d), the amount includible in an employee's gross income is determined under paragraphs (k)(2)(i)(A) through (C) of this section. For each employee— (A) The entire amount of salary reduction and employer flex-credits through a cafeteria plan for group-term life insurance coverage on the life of the employee is excludible from the employee's gross income, regardless of the amount of employer-provided group-term life insurance on the employee's life (that is, whether or not the coverage provided to the employee both through the cafeteria plan and outside the cafeteria plan exceeds $50,000); (B) The cost of the group-term life insurance in excess of $50,000 of coverage is includible in the employee's gross income. The amount includible in the employee's income is determined using the rules of § 1.79-3 and Table I ( Uniform Premiums for $1,000 of Group-Term Life Insurance Protection ). See subparagraph (C) of this paragraph (k)(2)(i) for determining the amount paid by the employee for purposes of reducing the Table I amount includible in income under § 1.79-3. (C) In determining the amount paid by the employee toward the purchase of the group-term life insurance for purposes of § 1.79-3, only an employee's after-tax contributions are treated as an amount paid by the employee. (ii) Examples. The rules in this paragraph (k) are illustrated by the following examples, in which the group-term life insurance coverage satisfies the nondiscrimination rules in section 79(d), provides no permanent benefits, is for a 12-month period, is the only group-term life insurance coverage provided under a policy carried directly or indirectly by the employer, and applies Table I ( Uniform Premiums for $1,000 of Group-Term Life Insurance Protection ) effective July 1, 1999: Example 1. Excess group-term life insurance coverage provided through salary reduction in a cafeteria plan. (i) Employer N provides group-term life insurance coverage to its employees only through its cafeteria plan. Employer N's cafeteria plan allows employees to elect salary reduction for group-term life insurance. Employee B, age 42, elected salary reduction of $200 for $150,000 of group-term life insurance. None of the group-term life insurance is paid through after-tax employee contributions. (ii) B's $200 of salary reduction for group-term life insurance is excludible from B's gross income under paragraph (k)(2)(i)(A). (iii) B has a total of $150,000 of group-term life insurance. The group-term life insurance in excess of the dollar limitation of section 79 is $100,000 (150,000-50,000). (iv) The Table I cost is $120 for $100,000 of group-term life insurance for an individual between ages 40 to 44. The Table I cost of $120 is reduced by zero (because B paid no portion of the group-term life insurance with after-tax employee contributions), under paragraphs (k)(2)(i)(A)-(B) of this section. (v) The amount includible in B's gross income for the $100,000 of excess group-term life insurance is $120. Example 2. Excess group-term life insurance coverage provided through salary reduction in a cafeteria plan where employee purchases a portion of group-term life insurance coverage with after-tax contributions. (i) Same facts as Example 1, except that B elected salary reduction of $100 and makes an after-tax contribution of $100 toward the purchase of group-term life insurance coverage. (ii) B's $100 of salary reduction for group-term life insurance is excludible from B's gross income, under paragraph (k)(2)(i)(A) of this section. (iii) B has a total of $150,000 of group-term life insurance. The group-term life insurance in excess of the dollar limitation of section 79 is $100,000 (150,000-50,000). (iv) The Table I cost is $120 for $100,000 of group-term life insurance for an individual between ages 40 to 44, under (k)(2)(i)(B). The Table I cost of $120 is reduced by $100 (because B paid $100 for the group-term life insurance with after-tax employee contributions), under paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section. (v) The amount includible in B's gross income for the $100,000 of excess group-term life insurance coverage is $20. Example 3. Excess group-term life insurance coverage provided through salary reduction in a cafeteria plan and outside a cafeteria plan. (i) Same facts as Example 1 except that Employer N also provides (at no cost to employees) group-term life insurance coverage equal to each employee's annual salary. Employee B's annual salary is $150,000. B has $150,000 of group-term life insurance directly from Employer N, and also $150,000 coverage through Employer N's cafeteria plan. (ii) B's $200 of salary reduction for group-term life insurance is excludible from B's gross income, under paragraph (k)(2)(i)(A) of this section. (iii) B has a total of $300,000 of group-term life insurance. The group-term life insurance in excess of the dollar limitation of section 79 is $250,000 (300,000-50,000). (iv) The Table I cost is $300 for $250,000 of group-term life insurance for an individual between ages 40 to 44. The Table I cost of $300 is reduced by zero (because B paid no portion of the group-term life insurance with after-tax employee contributions), under paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section. (v) The amount includible in B's gross income for the $250,000 of excess group-term life insurance is $300. Example 4. Excess group-term life insurance coverage provided through salary reduction in a cafeteria plan and outside a cafeteria plan. (i) Same facts as Example 3 except that Employee C's annual salary is $30,000. C has $30,000 of group-term life insurance coverage provided directly from Employer N, and elects an additional $30,000 of coverage for $40 through Employer N's cafeteria plan. C is 42 years old. (ii) C's $40 of salary reduction for group-term life insurance is excludible from C's gross income, under paragraph (k)(2)(i)(A) of this section. (iii) C has a total of $60,000 of group-term life insurance. The group-term life insurance in excess of the dollar limitation of section 79 is $10,000 (60,000-50,000). (iv) The Table I cost is $12 for $10,000 of group-term life insurance for an individual between ages 40 to 44. The Table I cost of $12 is reduced by zero (because C paid no portion of the group-term life insurance with after-tax employee contributions), under paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this section. (v) The amount includible in C's gross income for the $10,000 of excess group-term life insurance coverage is $12. (l) COBRA premiums —(1) Paying COBRA premiums through a cafeteria plan. Under § 1.125-4(c)(3)(iv), COBRA premiums for an employer-provided group health plan are qualified benefits if: (i) The premiums are excludible from an employee's income under section 106; or (ii) The premiums are for the accident and health plan of the employer sponsoring the cafeteria plan, even if the fair market value of the premiums is includible in an employee's gross income. See also paragraph (e)(2) in § 1.125-5 and § 54.4980B-2, Q & A-8 of this chapter for COBRA rules for health FSAs. (2) Example. The following example illustrates the rules of this paragraph (l): Example. COBRA premiums. (i) Employer O maintains a cafeteria plan for full-time employees, offering an election between cash and employer-provided accident and health insurance and other qualified benefits. Employees A, B, and C participate in the cafeteria plan. On July 1, 2009, Employee A has a qualifying event (as defined in § 54.4980B-4 of this chapter). (ii) Employee A was a full-time employee and became a part-time employee and for that reason, is no longer covered by Employer O's accident and health plan. Under § 1.125-4(f)(3)(ii), Employee A changes her election to salary reduce to pay her COBRA premiums. (iii) Employee B previously worked for another employer, quit and elected COBRA. Employee B begins work for Employer O on July 1, 2009, and becomes eligible to participate in Employer O's cafeteria plan on July 1, 2009, but will not be eligible to participate in Employer O's accident and health plan until October 1, 2009. Employee B elects to salary reduce to pay COBRA premiums for coverage under the accident and health plan sponsored by B's former employer. (iv) Employee C and C's spouse are covered by Employer O's accident and health plan until July 1, 2009, when C's divorce from her spouse became final. C continues to be covered by the accident and health plan. On July 1, 2009, C requests to pay COBRA premiums for her former spouse (who is not C's dependent (as defined in section 152)) with after-tax employee contributions. (v) Salary reduction elections for COBRA premiums for Employees A and B are qualified benefits for purposes of section 125 and are excludible from the gross income of Employees A and B. Employer O allows A and B to salary reduce for these COBRA premiums. (vi) Employer O allows C to pay for COBRA premiums for C's former spouse, with after-tax employee contributions because although accident and health coverage for C's former spouse is permitted in a cafeteria plan, the premiums are includible in C's gross income. (vii) The operation of Employer O's cafeteria plan satisfies the requirements of this paragraph (l). (m) Payment or reimbursement of employees' individual accident and health insurance premiums —(1) In general. The payment or reimbursement of employees' substantiated individual health insurance premiums is excludible from employees' gross income under section 106 and is a qualified benefit for purposes of section 125. (2) Example . The following example illustrates the rule of this paragraph (m): Example . Payment or reimbursement of premiums . (i) Employer P's cafeteria plan offers the following benefits for employees who are covered by an individual health insurance policy. The employee substantiates the expenses for the premiums for the policy (as required in paragraph (b)(2) in § 1.125-6) before any payments or reimbursements to the employee for premiums are made. The payments or reimbursements are made in the following ways: (ii) The cafeteria plan reimburses each employee directly for the amount of the employee's substantiated health insurance premium; (iii) The cafeteria plan issues the employee a check payable to the health insurance company for the amount of the employee's health insurance premium, which the employee is obligated to tender to the insurance company; (iv) The cafeteria plan issues a check in the same manner as (iii), except that the check is payable jointly to the employee and the insurance company; or (v) Under these circumstances, the individual health insurance policies are accident and health plans as defined in § 1.106-1. This benefit is a qualified benefit under section 125. (n) Section 105 rules for accident and health plan offered through a cafeteria plan —(1) General rule . In order for an accident and health plan to be a qualified benefit that is excludible from gross income if elected through a cafeteria plan, the cafeteria plan must satisfy section 125 and the accident and health plan must satisfy section 105(b) and (h). (2) Section 105(b) requirements in general . Section 105(b) provides an exclusion from gross income for amounts paid to an employee from an employer-funded accident and health plan specifically to reimburse the employee for certain expenses for medical care (as defined in section 213(d)) incurred by the employee or the employee's spouse or dependents during the period for which the benefit is provided to the employee (that is, when the employee is covered by the accident and health plan). (o) Prohibition against deferred compensation —(1) In general . Any plan that offers a benefit that defers compensation (except as provided in this paragraph (o)) is not a cafeteria plan. See section 125(d)(2)(A). A plan that permits employees to carry over unused elective contributions, after-tax contributions, or plan benefits from one plan year to another (except as provided in paragraphs (e), (o)(3) and (4) and (p) of this section) defers compensation. This is the case regardless of how the contributions or benefits are used by the employee in the subsequent plan year (for example, whether they are automatically or electively converted into another taxable or nontaxable benefit in the subsequent plan year or used to provide additional benefits of the same type). Similarly, a cafeteria plan also defers compensation if the plan permits employees to use contributions for one plan year to purchase a benefit that will be provided in a subsequent plan year (for example, life, health or disability if these benefits have a savings or investment feature, such as whole life insurance). See also Q & A-5 in § 1.125-3, prohibiting deferring compensation from one cafeteria plan year to a subsequent cafeteria plan year. See paragraph (e) of this section for grace period rules. A plan does not defer compensation merely because it allocates experience gains (or forfeitures) among participants in compliance with paragraph (o) in § 1.125-5. (2) Effect if a plan includes a benefit that defers the receipt of compensation or a plan operates to defer compensation . If a plan violates paragraph (o)(1) of this section, the availability of an election between taxable and nontaxable benefits under such a plan results in gross income to the employees. (3) Cash or deferred arrangements that may be offered in a cafeteria plan . (i) In general . A cafeteria plan may offer the benefits set forth in this paragraph (o)(3), even though these benefits defer compensation. (ii) Elective contributions to a section 401(k) plan . A cafeteria plan may permit a covered employee to elect to have the employer, on behalf of the employee, pay amounts as contributions to a trust that is part of a profit-sharing or stock bonus plan or rural cooperative plan (within the meaning of section 401(k)(7)), which includes a qualified cash or deferred arrangement (as defined in section 401(k)(2)). In addition, after-tax employee contributions under a qualified plan subject to section 401(m) are permitted through a cafeteria plan. The right to make such contributions does not cause a plan to fail to be a cafeteria plan merely because, under the qualified plan, employer matching contributions (as defined in section 401(m)(4)(A)) are made with respect to elective or after-tax employee contributions. (iii) Additional permitted deferred compensation arrangements . A plan maintained by an educational organization described in section 170(b)(1)(A)(ii) to the extent of amounts which a covered employee may elect to have the employer pay as contributions for post-retirement group life insurance is permitted through a cafeteria plan, if— (A) All contributions for such insurance must be made before retirement; and (B) Such life insurance does not have a cash surrender value at any time. (iv) Contributions to HSAs . Contributions to covered employees' HSAs as defined in section 223 (but not contributions to Archer MSAs). (4) Paid time off —(i) In general . A cafeteria plan is permitted to include elective paid time off (that is, vacation days, sick days or personal days) as a permitted taxable benefit through the plan by permitting employees to receive more paid time off than the employer otherwise provides to the employees on a nonelective basis, but only if the inclusion of elective paid time off through the plan does not operate to permit the deferral of compensation. In addition, a plan that only offers the choice of cash or paid time off is not a cafeteria plan and is not subject to the rules of section 125. In order to avoid deferral of compensation, the cafeteria plan must preclude any employee from using the paid time off or receiving cash, in a subsequent plan year, for any portion of such paid time off remaining unused as of the end of the plan year. (See paragraph (o)(4)(iii) of this section for the deadline to cash out unused elective paid time off.) For example, a plan that offers employees the opportunity to purchase paid time off (or to receive cash or other benefits through the plan in lieu of paid time off) is not a cafeteria plan if employees who purchase the paid time off for a plan year are allowed to use any unused paid time off in a subsequent plan year. This is the case even though the plan does not permit the employee to convert, in any subsequent plan year, the unused paid time off into any other benefit. (ii) Ordering of elective and nonelective paid time off . In determining whether a plan providing paid time off operates to permit the deferral of compensation, a cafeteria plan must provide that employees are deemed to use paid time off in the following order: (A) Nonelective paid time off . Nonelective paid time off (that is, paid time off with respect to which the employee has no election) is used first; (B) Elective paid time off . Elective paid time off is used after all nonelective paid time off is used. (iii) Cashing out or forfeiture of unused elective paid time off, in general . The cafeteria plan must provide that all unused elective paid time off (determined as of the last day of the plan year) must either be paid in cash (within the time specified in this paragraph (o)(4)) or be forfeited. This provision must apply uniformly to all participants in the cafeteria plan. (A) Cash out of unused elective paid time off . A plan does not operate to permit the deferral of compensation merely because the plan provides that an employee who has not used all elective paid time off for a plan year receives in cash the value of such unused paid time off. The employee must receive the cash on or before the last day of the cafeteria plan's plan year to which the elective contributions used to purchase the unused elective paid time off relate. (B) Forfeiture of unused elective paid time off . If the cafeteria plan provides for forfeiture of unused elective paid time off, the forfeiture must be effective on the last day of the plan year to which the elective contributions relate. (iv) No grace period for paid time off . The grace period described in paragraph (e) of this section does not apply to paid time off. (v) Examples . The following examples illustrate the rules of this paragraph (o)(4): Example 1 . Plan cashes out unused elective paid time off on or before the last day of the plan year . (i) Employer Q provides employees with two weeks of paid time off for each calendar year. Employer Q's human resources policy (that is, outside the cafeteria plan), permits employees to carry over one nonelective week of paid time off to the next year. Employer Q maintains a calendar year cafeteria plan that permits the employee to purchase, with elective contributions, an additional week of paid time off. (ii) For the 2009 plan year, Employee A (with a calendar tax year), timely elects to purchase one additional week of paid time off. During 2009, Employee A uses only two weeks of paid time off. Employee A is deemed to have used two weeks of nonelective paid time off and zero weeks of elective paid time off. (iii) Pursuant to the cafeteria plan, the plan pays Employee A the value of the unused elective paid time off week in cash on December 31, 2009. Employer Q includes this amount on the 2009 Form W-2 for Employee A. This amount is included in Employee A's gross income in 2009. The cafeteria plan's terms and operations do not violate the prohibition against deferring compensation. Example 2 . Unused nonelective paid time off carried over to next plan year . (i) Same facts as Example 1 , except that Employee A uses only one week of paid time off during the year. Pursuant to the cafeteria plan, Employee A is deemed to have used one nonelective week, and having retained one nonelective week and one elective week of paid time off. Employee A receives in cash the value of the unused elective paid time off on December 31, 2009. Employer Q includes this amount on the 2009 Form W-2 for Employee A. Employee A must report this amount as gross income in 2009. (ii) Pursuant to Employer Q's human resources policy, Employee A is permitted to carry over the one nonelective week of paid time off to the next year. Nonelective paid time off is not part of the cafeteria plan (that is, neither Employer Q nor the cafeteria plan permit employees to exchange nonelective paid time off for other benefits). (iii) The cafeteria plan's terms and operations do not violate the prohibition against deferring compensation. Example 3. Forfeiture of unused elective paid time off . Same facts as Example 2 , except that pursuant to the cafeteria plan, Employee A forfeits the remaining one week of elective paid time off. The cafeteria plan's terms and operations do not violate the prohibition against deferring compensation. Example 4 . Unused elective paid time off carried over to next plan year . Same facts as Example 1 , except that Employee A uses only two weeks of paid time off during the 2009 plan year, and, under the terms of the cafeteria plan, Employee A is treated as having used the two nonelective weeks and as having retained the one elective week. The one remaining week (that is, the elective week) is carried over to the next plan year (or the value thereof used for any other purpose in the next plan year). The plan operates to permit deferring compensation and is not a cafeteria plan. Example 5 . Paid time off exchanged for accident and health insurance premiums . Employer R provides employees with four weeks of paid time off for a year. Employer R's calendar year cafeteria plan permits employees to exchange up to one week of paid time off to pay the employee's share of accident and health insurance premiums. For the 2009 plan year, Employee B (with a calendar tax year), timely elects to exchange one week of paid time off (valued at $769) to pay accident and health insurance premiums for 2009. The $769 is excludible from Employee B's gross income under section 106. The cafeteria plan's terms and operations do not violate the prohibition against deferring compensation. (p) Benefits relating to more than one year —(1) Benefits in an accident and health insurance policy relating to more than one year . Consistent with section 125(d), an accident and health insurance policy may include certain benefits, as set forth in this paragraph (p)(1), without violating the prohibition against deferred compensation. (i) Permitted benefits . The following features or benefits of insurance policies do not defer compensation— (A) Credit toward the deductible for unreimbursed covered expenses incurred in prior periods; (B) Reasonable lifetime maximum limit on benefits; (C) Level premiums; (D) Premium waiver during disability; (E) Guaranteed policy renewability of coverage, without further evidence of insurability (but not guaranty of the amount of premium upon renewal); (F) Coverage for a specified accidental injury; (G) Coverage for a specified disease or illness, including payments at initial diagnosis of the specified disease or illness, and progressive payments of a set amount per month following the initial diagnosis (sometimes referred to as progressive diagnosis payments); and (H) Payment of a fixed amount per day (or other period) of hospitalization. (ii) Requirements of permitted benefits . All benefits described in paragraph (p)(1)(i) of this section must in addition satisfy all of the following requirements— (A) No part of any benefit is used in one plan year to purchase a benefit in a subsequent plan year; (B) The policies remain in force only so long as premiums are timely paid on a current basis, and, irrespective of the amount of premiums paid in prior plan years, if the current premiums are not paid, all coverage for new diseases or illnesses lapses. See paragraph (p)(1)(i)(D), allowing premium waiver during disability; (C) There is no investment fund or cash value to rely upon for payment of premiums; and (D) No part of any premium is held in a separate account for any participant or beneficiary, or otherwise segregated from the assets of the insurance company. (2) Benefits under a long-term disability policy relating to more than one year . A long-term disability policy paying disability benefits over more than one year does not violate the prohibition against deferring compensation. (3) Reasonable premium rebates or policy dividends . Reasonable premium rebates or policy dividends paid with respect to benefits provided through a cafeteria plan do not constitute impermissible deferred compensation if such rebates or dividends are paid before the close of the 12-month period immediately following the cafeteria plan year to which such rebates and dividends relate. (4) Mandatory two-year election for vision or dental insurance . When a cafeteria plan offers vision or dental insurance that requires a mandatory two-year coverage period, but not longer (sometimes referred to as a “two-year lock-in”), the mandatory two-year coverage period does not result in deferred compensation in violation of section 125(d)(2), provided both of the following requirements are satisfied— (i) The premiums for each plan year are paid no less frequently than annually; and (ii) In no event does a cafeteria plan use salary reduction or flex-credits relating to the first year of a two-year election to apply to vision or dental insurance for the second year of the two-year election. (5) Using salary reduction amounts from one plan year to pay accident and health insurance premiums for the first month of the immediately following plan year. (i) In general. Salary reduction amounts from the last month of one plan year of a cafeteria plan may be applied to pay accident and health insurance premiums for insurance during the first month of the immediately following plan year, if done on a uniform and consistent basis with respect to all participants (based on the usual payroll interval for each group of participants). (ii) Example. The following example illustrates the rules in this paragraph (p)(5): Example. Salary reduction payments in December of calendar plan year to pay accident and health insurance premiums for January. Employer S maintains a calendar year cafeteria plan. The cafeteria plan offers employees a salary reduction election for accident and health insurance. The plan provides that employees' salary reduction amounts for the last pay period in December are applied to pay accident and health insurance premiums for the immediately following January. All employees are paid bi-weekly. For the plan year ending December 31, 2009, Employee C elects salary reduction of $3,250 for accident and health coverage. For the last pay period in December 2009, $125 (3,250/26) is applied to the accident and health insurance premium for January 2010. This plan provision does not violate the prohibition against deferring compensation. (q) Nonqualified benefits —(1) In general. The following benefits are nonqualified benefits that are not permitted to be offered in a cafeteria plan— (i) Scholarships described in section 117; (ii) Employer-provided meals and lodging described in section 119; (iii) Educational assistance described in section 127; (iv) Fringe benefits described in section 132; (v) Long-term care insurance, or any product which is advertised, marketed or offered as long-term care insurance; (vi) Long-term care services (but see paragraph (q)(3) of this section); (vii) Group-term life insurance on the life of any individual other than an employee (whether includible or excludible from the employee's gross income); (viii) Health reimbursement arrangements (HRAs) that provide reimbursements up to a maximum dollar amount for a coverage period and that all or any unused amount at the end of a coverage period is carried forward to increase the maximum reimbursement amount in subsequent coverage periods; (ix) Contributions to Archer MSAs (section 220); and (x) Elective deferrals to a section 403(b) plan. (2) Nonqualified benefits not permitted in a cafeteria plan. The benefits described in this paragraph (q) are not qualified benefits or taxable benefits or cash for purposes of section 125 and thus may not be offered in a cafeteria plan regardless of whether any such benefit is purchased with after-tax employee contributions or on any other basis. A plan that offers a nonqualified benefit is not a cafeteria plan. Employees' elections between taxable and nontaxable benefits through such plan result in gross income to the participants for any benefit elected. See section 125(f). See paragraph (q)(3) of this section for special rule on long-term care insurance purchased through an HSA. (3) Long-term care insurance or services purchased through an HSA. Although long-term care insurance is not a qualified benefit and may not be offered in a cafeteria plan, a cafeteria plan is permitted to offer an HSA as a qualified benefit, and funds from the HSA may be used to pay eligible long-term care premiums on a qualified long-term care insurance contract or for qualified long-term care services. (r) Employer contributions to a cafeteria plan —(1) Salary reduction-in general. The term employer contributions means amounts that are not currently available (after taking section 125 into account) to the employee but are specified in the cafeteria plan as amounts that an employee may use for the purpose of electing benefits through the plan. A plan may provide that employer contributions may be made, in whole or in part, pursuant to employees' elections to reduce their compensation or to forgo increases in compensation and to have such amounts contributed, as employer contributions, by the employer on their behalf. See also § 1.125-5 (flexible spending arrangements). Also, a cafeteria plan is permitted to require employees to elect to pay the employees' share of any qualified benefit through salary reduction and not with after-tax employee contributions. A cafeteria plan is also permitted to pay reasonable cafeteria plan administrative fees through salary reduction amounts, and these salary reduction amounts are excludible from an employee's gross income. (2) Salary reduction as employer contribution. Salary reduction contributions are employer contributions. An employee's salary reduction election is an election to receive a contribution by the employer in lieu of salary or other compensation that is not currently available to the employee as of the effective date of the election and that does not subsequently become currently available to the employee. (3) Employer flex-credits. A cafeteria plan may also provide that the employer contributions will or may be made on behalf of employees equal to (or up to) specified amounts (or specified percentages of compensation) and that such nonelective contributions are available to employees for the election of benefits through the plan. (4) Elective contributions to a section 401(k) plan. See § 1.401(k)-1 for general rules relating to contributions to section 401(k) plans. (s) Effective/applicability date. It is proposed that these regulations apply on and after plan years beginning on or after January 1, 2009, except that the rule in paragraph (k)(2)(i)(B) of this section is effective as of the date the proposed regulations are published in the Federal Register .