26 U.S.C. § 125 — Cafeteria plans

(a) General rule. Normally, an employee's gross income does not include an amount just because a cafeteria plan lets them choose among the plan's benefits — as long as the exception in (b) doesn't apply. (b) Exception for highly compensated participants and key employees. (1) For a "highly compensated participant" (defined in (e)), the tax-free rule in (a) doesn't apply to any benefit from a plan year where the plan discriminates in favor of highly compensated people — either in who can join, or in contributions and benefits. (2) For a "key employee" (as defined in section 416(i)(1)), the tax-free rule doesn't apply if the qualified benefits given to key employees are more than 25 percent of all qualified benefits given to every employee under the plan; when figuring this, ignore the second sentence of subsection (f). (3) A benefit that loses its tax-free status under (1) or (2) counts as received in the participant's or key employee's tax year that includes the end of the plan year. (c) Discrimination as to benefits or contributions. For the (b)(1)(B) test, a plan does not discriminate if its qualified benefits and total benefits (or the employer's contributions toward them) don't favor highly compensated participants. (d) Cafeteria plan defined. (1) A "cafeteria plan" is a written plan where (A) everyone in it is an employee, and (B) participants can choose between cash and two or more qualified benefits. (2) A cafeteria plan cannot include deferred compensation, with three exceptions: (A) that's the general rule; (B) a profit-sharing, stock-bonus, or rural cooperative plan with a qualified cash-or-deferred (401(k)-style) arrangement can still count, for the part employees choose to have the employer pay in as contributions; (C) a plan run by certain educational institutions can still count, for employer-paid, pre-retirement group life insurance with no cash value, as long as all contributions happen before retirement — that life insurance is then treated as group-term life insurance for section 79 purposes; and (D) a plan can still count for amounts an employee chooses to have the employer contribute to a health savings account. (e) Highly compensated participant and individual defined. (1) A "highly compensated participant" is a participant who is (A) an officer, (B) someone who owns more than 5 percent of the employer's stock (by vote or value), (C) highly compensated, or (D) the spouse or dependent of someone in (A), (B), or (C) — using the section 152 definition of dependent, but ignoring three of its subparts. (2) A "highly compensated individual" is anyone described in (1)(A) through (D). (f) Qualified benefits defined. (1) A "qualified benefit" is any benefit that — because of this section's (a) — isn't included in the employee's gross income under some other specific tax-code provision (except sections 106(b), 117, 127, or 132). It also includes group-term life insurance that's taxable only because it's over the section 79 dollar limit, and any other benefit allowed by regulation. (2) Long-term care insurance is never a qualified benefit, no matter how it's marketed. (3) Certain health plans bought through an ACA insurance exchange are not qualified benefits either — (A) that's the general rule for exchange plans under section 1301(a) of the Patient Protection and Affordable Care Act offered through a section 1311 exchange — (B) except that this exclusion doesn't apply if the employee's employer is a small "qualified employer" (as defined in ACA section 1312(f)(2)) offering the employee an exchange plan through the group market. (g) Special rules. (1) A plan isn't discriminatory just because it's part of a collective bargaining agreement the Secretary finds genuine. (2) For the (b)(1)(B) health-benefit test, a plan isn't discriminatory if (A) every participant's contribution includes an amount that either (i) equals 100 percent of the cost of the majority of highly compensated participants' health coverage, or (ii) equals or exceeds 75 percent of the cost of the most expensive coverage among similarly situated participants, and (B) any contributions or benefits above that baseline are the same percentage of pay for everyone. (3) For the (b)(1)(A) eligibility test, a plan isn't discriminatory just because of its classification rules if (A) it covers a group of employees described in section 410(b)(2)(A)(i), and (B) it meets two conditions: (i) no employee needs more than 3 years of work with the employer to join, and that rule is the same for everyone, and (ii) once an employee meets that work requirement and is otherwise eligible, they start participating no later than the first day of the next plan year — unless they left the job before that day. (4) Employees who are treated as working for one combined employer under section 414's controlled-group rules are treated as one employer's employees for this section too. (h) Special rule for unused benefits when called to active duty. (1) A cafeteria plan, or a health flexible spending arrangement under it, doesn't stop qualifying as such just because it allows "qualified reservist distributions." (2) A "qualified reservist distribution" is a payout of some or all of an employee's account balance, if (A) the employee — because they're in a military reserve component — is ordered to active duty for more than 179 days or for an indefinite period, and (B) the payout happens between the order date and the last date the arrangement could otherwise pay reimbursements for that plan year. (i) Limitation on health flexible spending arrangements. (1) A health flexible spending arrangement funded by employer contributions only counts as a qualified benefit if the plan caps salary-reduction contributions to it at $2,500 per year per employee. (2) For tax years starting after December 31, 2013, that $2,500 cap rises each year with a cost-of-living adjustment (calculated using calendar year 2012 as the base year instead of 2016); any increase that isn't a multiple of $50 is rounded down to the nearest $50. (j) Simple cafeteria plans for small businesses. (1) A small business that runs a "simple cafeteria plan" meeting this subsection's rules for a year is treated as passing any nondiscrimination test for that year. (2) A "simple cafeteria plan" is one (A) set up and run by an "eligible employer," that (B) meets the contribution rules in (3) and the eligibility/participation rules in (4). (3) Contribution rules: (A) the employer must contribute for every qualified employee — no matter whether the employee also contributes — either (i) a flat percentage of pay of at least 2 percent, or (ii) an amount at least as much as the lesser of (I) 6 percent of pay or (II) twice what the employee contributed. (B) That (ii) option doesn't count if highly compensated or key employees get a better matching rate than everyone else. (C) The employer can add extra contributions beyond what's required, as long as (B) is still followed. (D) Key definitions here: a "salary reduction contribution" is money an employee elects to put into the plan tax-free; a "qualified employee" is an eligible employee who isn't highly compensated or a key employee; "highly compensated employee" and "key employee" use the meanings from sections 414(q) and 416(i). (4) Eligibility rules: (A) the plan must let in every employee who worked at least 1,000 hours in the prior plan year, and let each eligible employee choose any plan benefit under the same rules as everyone else. (B) The employer may still exclude employees who (i) aren't yet 21, (ii) have worked less than a year, (iii) are covered by a genuine collective bargaining agreement where benefits were actually negotiated, or (iv) are nonresident aliens working outside the U.S. (per section 410(b)(3)(C)); the plan can use a shorter service period or younger age instead. (5) "Eligible employer" means: (A) generally, an employer that averaged 100 or fewer employees on business days in either of the past two years (only counting years the employer existed); (B) for a new employer, its expected average number of employees for the current year; (C) an employer that qualified in a past "qualified year" and started a simple cafeteria plan then keeps being treated as eligible in later years for employees of the business the plan covered — (i) that's the rule — (ii) unless the employer grows to 200 or more employees in a later year, which ends the special treatment; (D) predecessor employers count as the same employer, and businesses treated as one employer under section 52(a)/(b) or section 414(n)/(o) are treated as one employer here too. (6) "Applicable nondiscrimination requirement" means the tests in subsection (b), section 79(d), section 105(h), or listed parts of section 129(d). (7) "Compensation" has the meaning given in section 414(s). (k) Cross reference. For reporting and recordkeeping rules, see section 6039D. (l) Regulations. The Secretary of the Treasury may issue whatever regulations are needed to carry out this section.