Bulletin No. 2007-39 September 24, 2007 …Bulletin No. 2007-39 September 24, 2007 HIGHLIGHTS OF THIS ISSUE These synopses are intended only as aids to the reader in identifying the

Bulletin No. 2007-39September 24, 2007

HIGHLIGHTSOF THIS ISSUEThese synopses are intended only as aids to the reader inidentifying the subject matter covered. They may not berelied upon as authoritative interpretations.

INCOME TAX

Rev. Rul. 2007–56, page 668.Interest rates; underpayments and overpayments. Therates of interest determined under section 6621 of the Codefor the calendar quarter beginning October 1, 2007, will be8 percent for overpayments (7 percent in the case of a cor-poration), 8 percent for underpayments, and 10 percent forlarge corporate underpayments. The rate of interest paid onthe portion of a corporate overpayment exceeding $10,000will be 5.5 percent.

T.D. 9349, page 668.This document removes temporary regulations under section125 of the Code relating to benefits that may be offered toparticipants under a cafeteria plan.

Rev. Proc. 2007–60, page 679.This procedure corrects the inflation adjusted amounts setforth in Rev. Proc. 2006–53, 2006–48 I.R.B. 996, thatapply to taxpayers who elect to expense certain depreciableassets under section 179 of the Code. This correction reflectsstatutory changes enacted subsequent to the publication ofRev. Proc. 2006–53. Rev. Proc. 2006–53 modified.

EMPLOYEE PLANS

REG–142695–05, page 681.Proposed regulations under section 125 of the Code pro-vide guidance on cafeteria plans. EE–16–79, EE–130–86,REG–243025–96, and REG–117162–99 withdrawn. Rev.Ruls. 69–141, 2002–41, 2003–102, 2005–24, 2006–36,

and Notices 89–110 and 2002–45 modified. A public hearingis scheduled for November 15, 2007.

REG–148393–06, page 714.Proposed regulations under section 402 of the Code clarifythat a payment from a qualified plan for an accident or healthinsurance premium generally constitutes a distribution undersection 402(a) that is taxable to the distributee under sec-tion 72 in the taxable year in which the premium is paid. Thetaxable amount generally would equal the amount of the pre-mium charged against the participant’s benefits under the plan.These regulations would also provide that a distribution for thepayment of the premium by a qualified plan generally is notexcluded from gross income under section 104, 105 or 106,but such distribution would constitute an amount paid for acci-dent or health insurance under section 213. A public hearingis scheduled for December 6, 2007.

Notice 2007–75, page 679.Weighted average interest rate update; corporate bondindices; 30-year Treasury securities. The weighted aver-age interest rate for September 2007 and the resulting permis-sible range of interest rates used to calculate current liabilityand to determine the required contribution are set forth.

(Continued on the next page)

Finding Lists begin on page ii.Index for July through September begins on page v.

EXEMPT ORGANIZATIONS

Announcement 2007–86, page 719.The IRS has revoked its determination that Museum of Amer-ican Piano of Bangor, PA; Transitional Living Collaborative ofMoraga, CA; Ken-Ray, Incorporated, of Orem, UT; DreamHomeFoundation of Sherwood, OR; Creativity Innovation Productivity,Incorporated, DBA Horizon Event Foundation of Highwood, MT;Community Fellowship for Battered Women of Silicon Valley,Inc., of San Jose, CA; Alta Crossing, Inc., of Nampa, ID; HomeBuyers Assistance Foundation, Inc., of Denver, CO; Interna-tional Housing Solutions, Inc., of Sacramento, CA; and FilipinoAmerican Community Development Council, Inc., of San Jose,CA, qualify as organizations described in sections 501(c)(3)and 170(c)(2) of the Code.

EMPLOYMENT TAX

T.D. 9356, page 675.Final regulations under section 7701 of the Code explainthat certain disregarded entities (qualified subchapter S sub-sidiaries and single-owner eligible entities) are to be treatedas entities separate from their owners for purposes of payingand reporting federal employment and certain excise taxes.Notice 99–6 obsoleted as of January 1, 2009.

EXCISE TAX

T.D. 9356, page 675.Final regulations under section 7701 of the Code explainthat certain disregarded entities (qualified subchapter S sub-sidiaries and single-owner eligible entities) are to be treatedas entities separate from their owners for purposes of payingand reporting federal employment and certain excise taxes.Notice 99–6 obsoleted as of January 1, 2009.

ADMINISTRATIVE

Announcement 2007–85, page 719.This document provides notice of cancellation of a publichearing on proposed regulations (REG–143797–06, 2007–26I.R.B. 1495) providing guidance on employer comparablecontributions to Health Savings Accounts (HSAs).

September 24, 2007 2007–39 I.R.B.

The IRS MissionProvide America’s taxpayers top quality service by helpingthem understand and meet their tax responsibilities and by

applying the tax law with integrity and fairness to all.

IntroductionThe Internal Revenue Bulletin is the authoritative instrument ofthe Commissioner of Internal Revenue for announcing officialrulings and procedures of the Internal Revenue Service and forpublishing Treasury Decisions, Executive Orders, Tax Conven-tions, legislation, court decisions, and other items of generalinterest. It is published weekly and may be obtained from theSuperintendent of Documents on a subscription basis. Bulletincontents are compiled semiannually into Cumulative Bulletins,which are sold on a single-copy basis.

It is the policy of the Service to publish in the Bulletin all sub-stantive rulings necessary to promote a uniform application ofthe tax laws, including all rulings that supersede, revoke, mod-ify, or amend any of those previously published in the Bulletin.All published rulings apply retroactively unless otherwise indi-cated. Procedures relating solely to matters of internal man-agement are not published; however, statements of internalpractices and procedures that affect the rights and duties oftaxpayers are published.

Revenue rulings represent the conclusions of the Service on theapplication of the law to the pivotal facts stated in the revenueruling. In those based on positions taken in rulings to taxpayersor technical advice to Service field offices, identifying detailsand information of a confidential nature are deleted to preventunwarranted invasions of privacy and to comply with statutoryrequirements.

Rulings and procedures reported in the Bulletin do not have theforce and effect of Treasury Department Regulations, but theymay be used as precedents. Unpublished rulings will not berelied on, used, or cited as precedents by Service personnel inthe disposition of other cases. In applying published rulings andprocedures, the effect of subsequent legislation, regulations,

court decisions, rulings, and procedures must be considered,and Service personnel and others concerned are cautionedagainst reaching the same conclusions in other cases unlessthe facts and circumstances are substantially the same.

The Bulletin is divided into four parts as follows:

Part I.—1986 Code.This part includes rulings and decisions based on provisions ofthe Internal Revenue Code of 1986.

Part II.—Treaties and Tax Legislation.This part is divided into two subparts as follows: Subpart A,Tax Conventions and Other Related Items, and Subpart B, Leg-islation and Related Committee Reports.

Part III.—Administrative, Procedural, and Miscellaneous.To the extent practicable, pertinent cross references to thesesubjects are contained in the other Parts and Subparts. Alsoincluded in this part are Bank Secrecy Act Administrative Rul-ings. Bank Secrecy Act Administrative Rulings are issued bythe Department of the Treasury’s Office of the Assistant Sec-retary (Enforcement).

Part IV.—Items of General Interest.This part includes notices of proposed rulemakings, disbar-ment and suspension lists, and announcements.

The last Bulletin for each month includes a cumulative indexfor the matters published during the preceding months. Thesemonthly indexes are cumulated on a semiannual basis, and arepublished in the last Bulletin of each semiannual period.

The contents of this publication are not copyrighted and may be reprinted freely. A citation of the Internal Revenue Bulletin as the source would be appropriate.

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, DC 20402.

2007–39 I.R.B. September 24, 2007

Place missing child here.

September 24, 2007 2007–39 I.R.B.

Part I. Rulings and Decisions Under the Internal Revenue Codeof 1986Section 125.—CafeteriaPlans26 CFR 1.125–2T: Cafeteria plan elections.

T.D. 9349

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Part 1

Employee Benefits —Cafeteria Plans

AGENCY: Internal Revenue Service(IRS), Treasury.

ACTION: Removal of temporary regula-tions.

SUMMARY: This document removes thetemporary regulations pertaining to ben-efits that may be offered to participantsunder a section 125 cafeteria plan. Thetemporary regulations were published inthe Federal Register on February 4, 1986.Guidance issued by the IRS and the Trea-sury Department under section 125 havemade these temporary regulations obso-lete.

DATES: Effective Dates: These regula-tions are effective August 1, 2007.

FOR FURTHER INFORMATIONCONTACT: Mireille Khoury at (202)622–6080 (not a toll-free number).

SUPPLEMENTARY INFORMATION:

Background

On February 4, 1986, the IRS and Trea-sury Department published temporary reg-ulations on section 125. The temporaryregulations were published in the FederalRegister (T.D. 8073, 1986–1 C.B. 45 [51FR 4318]) as section 1.125–2T. A notice ofproposed rulemaking issued under section125 (REG–142695–05, this Bulletin) andother guidance issued by the IRS and theTreasury Department under section 125have made these temporary regulations ob-solete. The temporary regulations are re-moved.

Special Analyses

It has been determined that this removalof temporary regulations is not a signifi-cant regulatory action as defined in Exec-utive Order 12866. Therefore, a regula-tory assessment is not required. It also hasbeen determined that section 553(b) of theAdministrative Procedure Act (5 U.S.C.chapter 5) does not apply to this removalof temporary regulations. This removalof temporary regulations does not imposea collection of information on small en-tities, thus the Regulatory Flexibility Act(5 U.S.C. chapter 6) does not apply. Pur-suant to section 7805(f) of the Code, thepreceding temporary regulations were sub-mitted to the Chief Counsel for Advocacyof the Small Business Administration forcomment on its impact on small business.

Drafting Information

The principal author of this removal oftemporary regulations is Mireille Khoury,Office of Division Counsel/AssociateChief Counsel (Tax Exempt and Govern-ment Entities). However, personnel fromTreasury participated in its development.

* * * * *

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amendedas follows:

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

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

§1.125–2T [Removed]

Par. 2. Section 1.125–2T is removed.

Kevin M. Brown,Deputy Commissioner forServices and Enforcement.

Approved July 24, 2007.

Eric Solomon,Assistant Secretary of

the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on July 31, 2007,8:45 a.m., and published in the issue of the Federal Registerfor August 1, 2007, 72 F.R. 41891)

Section 6621.—Determina-tion of Rate of Interest26 CFR 301.6621–1: Interest rate.

Interest rates; underpayments andoverpayments. The rates of interest de-termined under section 6621 of the Codefor the calendar quarter beginning Octo-ber 1, 2007, will be 8 percent for overpay-ments (7 percent in the case of a corpo-ration), 8 percent for underpayments, and10 percent for large corporate underpay-ments. The rate of interest paid on the por-tion of a corporate overpayment exceeding$10,000 will be 5.5 percent.

Rev. Rul. 2007–56

Section 6621 of the Internal RevenueCode establishes the rates for intereston tax overpayments and tax underpay-ments. Under section 6621(a)(1), theoverpayment rate is the sum of the federalshort-term rate plus 3 percentage points(2 percentage points in the case of a cor-poration), except the rate for the portionof a corporate overpayment of tax exceed-ing $10,000 for a taxable period is thesum of the federal short-term rate plus0.5 of a percentage point. Under section6621(a)(2), the underpayment rate is thesum of the federal short-term rate plus 3percentage points.

Section 6621(c) provides that for pur-poses of interest payable under section6601 on any large corporate underpay-ment, the underpayment rate under section6621(a)(2) is determined by substituting“5 percentage points” for “3 percentagepoints.” See section 6621(c) and section301.6621–3 of the Regulations on Proce-dure and Administration for the definitionof a large corporate underpayment andfor the rules for determining the appli-cable date. Section 6621(c) and section301.6621–3 are generally effective forperiods after December 31, 1990.

Section 6621(b)(1) provides that theSecretary will determine the federalshort-term rate for the first month in eachcalendar quarter.

Section 6621(b)(2)(A) provides that thefederal short-term rate determined undersection 6621(b)(1) for any month applies

2007–39 I.R.B. 668 September 24, 2007

during the first calendar quarter beginningafter such month.

Section 6621(b)(3) provides that thefederal short-term rate for any month isthe federal short-term rate determinedduring such month by the Secretary inaccordance with section 1274(d), roundedto the nearest full percent (or, if a multipleof 1/2 of 1 percent, the rate is increased tothe next highest full percent).

Notice 88–59, 1988–1 C.B. 546, an-nounced that, in determining the quarterlyinterest rates to be used for overpaymentsand underpayments of tax under section6621, the Internal Revenue Service willuse the federal short-term rate based ondaily compounding because that rate ismost consistent with section 6621 which,

pursuant to section 6622, is subject to dailycompounding.

Rounded to the nearest full percent, thefederal short-term rate based on daily com-pounding determined during the month ofJuly 2007 is 5 percent. Accordingly, anoverpayment rate of 8 percent (7 percentin the case of a corporation) and an under-payment rate of 8 percent are establishedfor the calendar quarter beginning October1, 2007. The overpayment rate for the por-tion of a corporate overpayment exceeding$10,000 for the calendar quarter beginningOctober 1, 2007, is 5.5 percent. The un-derpayment rate for large corporate under-payments for the calendar quarter begin-ning October 1, 2007, is 10 percent. Theserates apply to amounts bearing interest dur-ing that calendar quarter.

Interest factors for daily compound in-terest for annual rates of 5.5 percent, 7 per-cent, 8 percent, and 10 percent are pub-lished in Tables 16, 19, 21, and 25 of Rev.Proc. 95–17, 1995–1 C.B. 556, 570, 573,575, and 579.

Annual interest rates to be compoundeddaily pursuant to section 6622 that applyfor prior periods are set forth in the tablesaccompanying this revenue ruling.

DRAFTING INFORMATION

The principal author of this revenueruling is Wendy Kribell of the Office ofAssociate Chief Counsel (Procedure &Administration). For further informa-tion regarding this revenue ruling, contactMs. Kribell at (202) 622–4570 (not atoll-free call).

TABLE OF INTEREST RATES

PERIODS BEFORE JUL. 1, 1975 — PERIODS ENDING DEC. 31, 1986

OVERPAYMENTS AND UNDERPAYMENTS

PERIOD RATEIn 1995–1 C.B.

DAILY RATE TABLE

Before Jul. 1, 1975 6% Table 2, pg. 557Jul. 1, 1975—Jan. 31, 1976 9% Table 4, pg. 559Feb. 1, 1976—Jan. 31, 1978 7% Table 3, pg. 558Feb. 1, 1978—Jan. 31, 1980 6% Table 2, pg. 557Feb. 1, 1980—Jan. 31, 1982 12% Table 5, pg. 560Feb. 1, 1982—Dec. 31, 1982 20% Table 6, pg. 560Jan. 1, 1983—Jun. 30, 1983 16% Table 37, pg. 591Jul. 1, 1983—Dec. 31, 1983 11% Table 27, pg. 581Jan. 1, 1984—Jun. 30, 1984 11% Table 75, pg. 629Jul. 1, 1984—Dec. 31, 1984 11% Table 75, pg. 629Jan. 1, 1985—Jun. 30, 1985 13% Table 31, pg. 585Jul. 1, 1985—Dec. 31, 1985 11% Table 27, pg. 581Jan. 1, 1986—Jun. 30, 1986 10% Table 25, pg. 579Jul. 1, 1986—Dec. 31, 1986 9% Table 23, pg. 577


FROM JAN. 1, 1987 — DEC. 31, 1998

OVERPAYMENTS UNDERPAYMENTS

1995–1 C.B. 1995–1 C.B.RATE TABLE PG RATE TABLE PG

Jan. 1, 1987—Mar. 31, 1987 8% 21 575 9% 23 577Apr. 1, 1987—Jun. 30, 1987 8% 21 575 9% 23 577Jul. 1, 1987—Sep. 30, 1987 8% 21 575 9% 23 577Oct. 1, 1987—Dec. 31, 1987 9% 23 577 10% 25 579Jan. 1, 1988—Mar. 31, 1988 10% 73 627 11% 75 629Apr. 1, 1988—Jun. 30, 1988 9% 71 625 10% 73 627Jul. 1, 1988—Sep. 30, 1988 9% 71 625 10% 73 627Oct. 1, 1988—Dec. 31, 1988 10% 73 627 11% 75 629Jan. 1, 1989—Mar. 31, 1989 10% 25 579 11% 27 581

September 24, 2007 669 2007–39 I.R.B.


FROM JAN. 1, 1987 — DEC. 31, 1998 – Continued



Apr. 1, 1989—Jun. 30, 1989 11% 27 581 12% 29 583Jul. 1, 1989—Sep. 30, 1989 11% 27 581 12% 29 583Oct. 1, 1989—Dec. 31, 1989 10% 25 579 11% 27 581Jan. 1, 1990—Mar. 31, 1990 10% 25 579 11% 27 581Apr. 1, 1990—Jun. 30, 1990 10% 25 579 11% 27 581Jul. 1, 1990—Sep. 30, 1990 10% 25 579 11% 27 581Oct. 1, 1990—Dec. 31, 1990 10% 25 579 11% 27 581Jan. 1, 1991—Mar. 31, 1991 10% 25 579 11% 27 581Apr. 1, 1991—Jun. 30, 1991 9% 23 577 10% 25 579Jul. 1, 1991—Sep. 30, 1991 9% 23 577 10% 25 579Oct. 1, 1991—Dec. 31, 1991 9% 23 577 10% 25 579Jan. 1, 1992—Mar. 31, 1992 8% 69 623 9% 71 625Apr. 1, 1992—Jun. 30, 1992 7% 67 621 8% 69 623Jul. 1, 1992—Sep. 30, 1992 7% 67 621 8% 69 623Oct. 1, 1992—Dec. 31, 1992 6% 65 619 7% 67 621Jan. 1, 1993—Mar. 31, 1993 6% 17 571 7% 19 573Apr. 1, 1993—Jun. 30, 1993 6% 17 571 7% 19 573Jul. 1, 1993—Sep. 30, 1993 6% 17 571 7% 19 573Oct. 1, 1993—Dec. 31, 1993 6% 17 571 7% 19 573Jan. 1, 1994—Mar. 31, 1994 6% 17 571 7% 19 573Apr. 1, 1994—Jun. 30, 1994 6% 17 571 7% 19 573Jul. 1, 1994—Sep. 30, 1994 7% 19 573 8% 21 575Oct. 1, 1994—Dec. 31, 1994 8% 21 575 9% 23 577Jan. 1, 1995—Mar. 31, 1995 8% 21 575 9% 23 577Apr. 1, 1995—Jun. 30, 1995 9% 23 577 10% 25 579Jul. 1, 1995—Sep. 30, 1995 8% 21 575 9% 23 577Oct. 1, 1995—Dec. 31, 1995 8% 21 575 9% 23 577Jan. 1, 1996—Mar. 31, 1996 8% 69 623 9% 71 625Apr. 1, 1996—Jun. 30, 1996 7% 67 621 8% 69 623Jul. 1, 1996—Sep. 30, 1996 8% 69 623 9% 71 625Oct. 1, 1996—Dec. 31, 1996 8% 69 623 9% 71 625Jan. 1, 1997—Mar. 31, 1997 8% 21 575 9% 23 577Apr. 1, 1997—Jun. 30, 1997 8% 21 575 9% 23 577Jul. 1, 1997—Sep. 30, 1997 8% 21 575 9% 23 577Oct. 1, 1997—Dec. 31, 1997 8% 21 575 9% 23 577Jan. 1, 1998—Mar. 31, 1998 8% 21 575 9% 23 577Apr. 1, 1998—Jun. 30, 1998 7% 19 573 8% 21 575Jul. 1, 1998—Sep. 30, 1998 7% 19 573 8% 21 575Oct. 1, 1998—Dec. 31, 1998 7% 19 573 8% 21 575


FROM JANUARY 1, 1999 — PRESENT

NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS

1995–1 C.B.RATE TABLE PAGE

Jan. 1, 1999—Mar. 31, 1999 7% 19 573Apr. 1, 1999—Jun. 30, 1999 8% 21 575Jul. 1, 1999—Sep. 30, 1999 8% 21 575Oct. 1, 1999—Dec. 31, 1999 8% 21 575Jan. 1, 2000—Mar. 31, 2000 8% 69 623Apr. 1, 2000—Jun. 30, 2000 9% 71 625Jul. 1, 2000—Sep. 30, 2000 9% 71 625

2007–39 I.R.B. 670 September 24, 2007


FROM JANUARY 1, 1999 — PRESENT – Continued

NONCORPORATE OVERPAYMENTS AND UNDERPAYMENTS

1995–1 C.B.RATE TABLE PAGE

Oct. 1, 2000—Dec. 31, 2000 9% 71 625Jan. 1, 2001—Mar. 31, 2001 9% 23 577Apr. 1, 2001—Jun. 30, 2001 8% 21 575Jul. 1, 2001—Sep. 30, 2001 7% 19 573Oct. 1, 2001—Dec. 31, 2001 7% 19 573Jan. 1, 2002—Mar. 31, 2002 6% 17 571Apr. 1, 2002—Jun. 30, 2002 6% 17 571Jul. 1, 2002—Sep. 30, 2002 6% 17 571Oct. 1, 2002—Dec. 31, 2002 6% 17 571Jan. 1, 2003—Mar. 31, 2003 5% 15 569Apr. 1, 2003—Jun. 30, 2003 5% 15 569Jul. 1, 2003—Sep. 30, 2003 5% 15 569Oct. 1, 2003—Dec. 31, 2003 4% 13 567Jan. 1, 2004—Mar. 31, 2004 4% 61 615Apr. 1, 2004—Jun. 30, 2004 5% 63 617Jul. 1, 2004—Sep. 30, 2004 4% 61 615Oct. 1, 2004—Dec. 31, 2004 5% 63 617Jan. 1, 2005—Mar. 31, 2005 5% 15 569Apr. 1, 2005—Jun. 30, 2005 6% 17 571Jul. 1, 2005—Sep. 30, 2005 6% 17 571Oct. 1, 2005—Dec. 31, 2005 7% 19 573Jan. 1, 2006—Mar. 31, 2006 7% 19 573Apr. 1, 2006—Jun. 30, 2006 7% 19 573Jul. 1, 2006—Sep. 30, 2006 8% 21 575Oct. 1, 2006—Dec. 31, 2006 8% 21 575Jan. 1, 2007—Mar. 31, 2007 8% 21 575Apr. 1, 2007—Jun. 30, 2007 8% 21 575Jul. 1, 2007—Sep. 30, 2007 8% 21 575Oct. 1, 2007—Dec. 31, 2007 8% 21 575



CORPORATE OVERPAYMENTS AND UNDERPAYMENTS



Jan. 1, 1999—Mar. 31, 1999 6% 17 571 7% 19 573Apr. 1, 1999—Jun. 30, 1999 7% 19 573 8% 21 575Jul. 1, 1999—Sep. 30, 1999 7% 19 573 8% 21 575Oct. 1, 1999—Dec. 31, 1999 7% 19 573 8% 21 575Jan. 1, 2000—Mar. 31, 2000 7% 67 621 8% 69 623Apr. 1, 2000—Jun. 30, 2000 8% 69 623 9% 71 625Jul. 1, 2000—Sep. 30, 2000 8% 69 623 9% 71 625Oct. 1, 2000—Dec. 31, 2000 8% 69 623 9% 71 625Jan. 1, 2001—Mar. 31, 2001 8% 21 575 9% 23 577Apr. 1, 2001—Jun. 30, 2001 7% 19 573 8% 21 575Jul. 1, 2001—Sep. 30, 2001 6% 17 571 7% 19 573Oct. 1, 2001—Dec. 31, 2001 6% 17 571 7% 19 573Jan. 1, 2002—Mar. 31, 2002 5% 15 569 6% 17 571Apr. 1, 2002—Jun. 30, 2002 5% 15 569 6% 17 571Jul. 1, 2002—Sep. 30, 2002 5% 15 569 6% 17 571

September 24, 2007 671 2007–39 I.R.B.



CORPORATE OVERPAYMENTS AND UNDERPAYMENTS



Oct. 1, 2002—Dec. 31, 2002 5% 15 569 6% 17 571Jan. 1, 2003—Mar. 31, 2003 4% 13 567 5% 15 569Apr. 1, 2003—Jun. 30, 2003 4% 13 567 5% 15 569Jul. 1, 2003—Sep. 30, 2003 4% 13 567 5% 15 569Oct. 1, 2003—Dec. 31, 2003 3% 11 565 4% 13 567Jan. 1, 2004—Mar. 31, 2004 3% 59 613 4% 61 615Apr. 1, 2004—Jun. 30, 2004 4% 61 615 5% 63 617Jul. 1, 2004—Sep. 30, 2004 3% 59 613 4% 61 615Oct. 1, 2004—Dec. 31, 2004 4% 61 615 5% 63 617Jan. 1, 2005—Mar. 31, 2005 4% 13 567 5% 15 569Apr. 1, 2005—Jun. 30, 2005 5% 15 569 6% 17 571Jul. 1, 2005—Sep. 30, 2005 5% 15 569 6% 17 571Oct. 1, 2005—Dec. 31, 2005 6% 17 571 7% 19 573Jan. 1, 2006—Mar. 31, 2006 6% 17 571 7% 19 573Apr. 1, 2006—Jun. 30, 2006 6% 17 571 7% 19 573Jul. 1, 2006—Sep. 30, 2006 7% 19 573 8% 21 575Oct. 1, 2006—Dec. 31, 2006 7% 19 573 8% 21 575Jan. 1, 2007—Mar. 31, 2007 7% 19 573 8% 21 575Apr. 1, 2007—Jun. 30, 2007 7% 19 573 8% 21 575Jul. 1, 2007—Sep. 30, 2007 7% 19 573 8% 21 575Oct. 1, 2007—Dec. 31, 2007 7% 19 573 8% 21 575

TABLE OF INTEREST RATES FORLARGE CORPORATE UNDERPAYMENTS


1995–1 C.B.RATE TABLE PG

Jan. 1, 1991—Mar. 31, 1991 13% 31 585Apr. 1, 1991—Jun. 30, 1991 12% 29 583Jul. 1, 1991—Sep. 30, 1991 12% 29 583Oct. 1, 1991—Dec. 31, 1991 12% 29 583Jan. 1, 1992—Mar. 31, 1992 11% 75 629Apr. 1, 1992—Jun. 30, 1992 10% 73 627Jul. 1, 1992—Sep. 30, 1992 10% 73 627Oct. 1, 1992—Dec. 31, 1992 9% 71 625Jan. 1, 1993—Mar. 31, 1993 9% 23 577Apr. 1, 1993—Jun. 30, 1993 9% 23 577Jul. 1, 1993—Sep. 30, 1993 9% 23 577Oct. 1, 1993—Dec. 31, 1993 9% 23 577Jan. 1, 1994—Mar. 31, 1994 9% 23 577Apr. 1, 1994—Jun. 30, 1994 9% 23 577Jul. 1, 1994—Sep. 30, 1994 10% 25 579Oct. 1, 1994—Dec. 31, 1994 11% 27 581Jan. 1, 1995—Mar. 31, 1995 11% 27 581Apr. 1, 1995—Jun. 30, 1995 12% 29 583Jul. 1, 1995—Sep. 30, 1995 11% 27 581Oct. 1, 1995—Dec. 31, 1995 11% 27 581Jan. 1, 1996—Mar. 31, 1996 11% 75 629Apr. 1, 1996—Jun. 30, 1996 10% 73 627Jul. 1, 1996—Sep. 30, 1996 11% 75 629Oct. 1, 1996—Dec. 31, 1996 11% 75 629

2007–39 I.R.B. 672 September 24, 2007

TABLE OF INTEREST RATES FORLARGE CORPORATE UNDERPAYMENTS



Jan. 1, 1997—Mar. 31, 1997 11% 27 581Apr. 1, 1997—Jun. 30, 1997 11% 27 581Jul. 1, 1997—Sep. 30, 1997 11% 27 581Oct. 1, 1997—Dec. 31, 1997 11% 27 581Jan. 1, 1998—Mar. 31, 1998 11% 27 581Apr. 1, 1998—Jun. 30, 1998 10% 25 579Jul. 1, 1998—Sep. 30, 1998 10% 25 579Oct. 1, 1998—Dec. 31, 1998 10% 25 579Jan. 1, 1999—Mar. 31, 1999 9% 23 577Apr. 1, 1999—Jun. 30, 1999 10% 25 579Jul. 1, 1999—Sep. 30, 1999 10% 25 579Oct. 1, 1999—Dec. 31, 1999 10% 25 579Jan. 1, 2000—Mar. 31, 2000 10% 73 627Apr. 1, 2000—Jun. 30, 2000 11% 75 629Jul. 1, 2000—Sep. 30, 2000 11% 75 629Oct. 1, 2000—Dec. 31, 2000 11% 75 629Jan. 1, 2001—Mar. 31, 2001 11% 27 581Apr. 1, 2001—Jun. 30, 2001 10% 25 579Jul. 1, 2001—Sep. 30, 2001 9% 23 577Oct. 1, 2001—Dec. 31, 2001 9% 23 577Jan. 1, 2002—Mar. 31, 2002 8% 21 575Apr. 1, 2002—Jun. 30, 2002 8% 21 575Jul. 1, 2002—Sep. 30, 2002 8% 21 575Oct. 1, 2002—Dec. 31, 2002 8% 21 575Jan. 1, 2003—Mar. 31, 2003 7% 19 573Apr. 1, 2003—Jun. 30, 2003 7% 19 573Jul. 1, 2003—Sep. 30, 2003 7% 19 573Oct. 1, 2003—Dec. 31, 2003 6% 17 571Jan. 1, 2004—Mar. 31, 2004 6% 65 619Apr. 1, 2004—Jun. 30, 2004 7% 67 621Jul. 1, 2004—Sep. 30, 2004 6% 65 619Oct. 1, 2004—Dec. 31, 2004 7% 67 621Jan. 1, 2005—Mar. 31, 2005 7% 19 573Apr. 1, 2005—Jun. 30, 2005 8% 21 575Jul. 1, 2005—Sep. 30, 2005 8% 21 575Oct. 1, 2005—Dec. 31, 2005 9% 23 577Jan. 1, 2006—Mar. 31, 2006 9% 23 577Apr. 1, 2006—Jun. 30, 2006 9% 23 577Jul. 1, 2006—Sep. 30, 2006 10% 25 579Oct. 1, 2006—Dec. 31, 2006 10% 25 579Jan. 1, 2007—Mar. 31, 2007 10% 25 579Apr. 1, 2007—Jun. 30, 2007 10% 25 579Jul. 1, 2007—Sep. 30, 2007 10% 25 579Oct. 1, 2007—Dec. 31, 2007 10% 25 579

TABLE OF INTEREST RATES FOR CORPORATEOVERPAYMENTS EXCEEDING $10,000



Jan. 1, 1995—Mar. 31, 1995 6.5% 18 572Apr. 1, 1995—Jun. 30, 1995 7.5% 20 574

September 24, 2007 673 2007–39 I.R.B.

TABLE OF INTEREST RATES FOR CORPORATEOVERPAYMENTS EXCEEDING $10,000



Jul. 1, 1995—Sep. 30, 1995 6.5% 18 572Oct. 1, 1995—Dec. 31, 1995 6.5% 18 572Jan. 1, 1996—Mar. 31, 1996 6.5% 66 620Apr. 1, 1996—Jun. 30, 1996 5.5% 64 618Jul. 1, 1996—Sep. 30, 1996 6.5% 66 620Oct. 1, 1996—Dec. 31, 1996 6.5% 66 620Jan. 1, 1997—Mar. 31, 1997 6.5% 18 572Apr. 1, 1997—Jun. 30, 1997 6.5% 18 572Jul. 1, 1997—Sep. 30, 1997 6.5% 18 572Oct. 1, 1997—Dec. 31, 1997 6.5% 18 572Jan. 1, 1998—Mar. 31, 1998 6.5% 18 572Apr. 1, 1998—Jun. 30, 1998 5.5% 16 570Jul. 1, 1998—Sep. 30, 1998 5.5% 16 570Oct. 1, 1998—Dec. 31, 1998 5.5% 16 570Jan. 1, 1999—Mar. 31, 1999 4.5% 14 568Apr. 1, 1999—Jun. 30, 1999 5.5% 16 570Jul. 1, 1999—Sep. 30, 1999 5.5% 16 570Oct. 1, 1999—Dec. 31, 1999 5.5% 16 570Jan. 1, 2000—Mar. 31, 2000 5.5% 64 618Apr. 1, 2000—Jun. 30, 2000 6.5% 66 620Jul. 1, 2000—Sep. 30, 2000 6.5% 66 620Oct. 1, 2000—Dec. 31, 2000 6.5% 66 620Jan. 1, 2001—Mar. 31, 2001 6.5% 18 572Apr. 1, 2001—Jun. 30, 2001 5.5% 16 570Jul. 1, 2001—Sep. 30, 2001 4.5% 14 568Oct. 1, 2001—Dec. 31, 2001 4.5% 14 568Jan. 1, 2002—Mar. 31, 2002 3.5% 12 566Apr. 1, 2002—Jun. 30, 2002 3.5% 12 566Jul. 1, 2002—Sep. 30, 2002 3.5% 12 566Oct. 1, 2002—Dec. 31, 2002 3.5% 12 566Jan. 1, 2003—Mar. 31, 2003 2.5% 10 564Apr. 1, 2003—Jun. 30, 2003 2.5% 10 564Jul. 1, 2003—Sep. 30, 2003 2.5% 10 564Oct. 1, 2003—Dec. 31, 2003 1.5% 8 562Jan. 1, 2004—Mar. 31, 2004 1.5% 56 610Apr. 1, 2004—Jun. 30, 2004 2.5% 58 612Jul. 1, 2004—Sep. 30, 2004 1.5% 56 610Oct. 1, 2004—Dec. 31, 2004 2.5% 58 612Jan. 1, 2005—Mar. 31, 2005 2.5% 10 564Apr. 1, 2005—Jun. 30, 2005 3.5% 12 566Jul. 1, 2005—Sep. 30, 2005 3.5% 12 566Oct. 1, 2005—Dec. 31, 2005 4.5% 14 568Jan. 1, 2006—Mar. 31, 2006 4.5% 14 568Apr. 1, 2006—Jun. 30, 2006 4.5% 14 568Jul. 1, 2006—Sep. 30, 2006 5.5% 16 570Oct. 1, 2006—Dec. 31, 2006 5.5% 16 570Jan. 1, 2007—Mar. 31, 2007 5.5% 16 570Apr. 1, 2007—Jun. 30, 2007 5.5% 16 570Jul. 1, 2007—Sep. 30, 2007 5.5% 16 570Oct. 1, 2007—Dec. 31, 2007 5.5% 16 570

2007–39 I.R.B. 674 September 24, 2007

Section 7701.—Definitions

26 CFR 301.7701–2: Business entities; definitions.

T.D. 9356

DEPARTMENT OFTHE TREASURYInternal Revenue Service26 CFR Parts 1 and 301

Disregarded Entities;Employment and ExciseTaxes


ACTION: Final regulations.

SUMMARY: This document contains fi-nal regulations under which qualified sub-chapter S subsidiaries and single-ownereligible entities that currently are disre-garded as entities separate from their own-ers for Federal tax purposes will be treatedas separate entities for employment tax andrelated reporting requirement purposes.This document also contains final regula-tions that treat such disregarded entitiesas separate entities for purposes of cer-tain excise taxes reported on Forms 720,“Quarterly Federal Excise Tax Return;”730, “Monthly Tax Return for Wagers;”2290, “Heavy Highway Vehicle Use TaxReturn;” and 11–C, “Occupational Taxand Registration Return for Wagering;”excise tax refunds or payments claimed onForm 8849, “Claim for Refund of ExciseTaxes;” and excise tax registrations onForm 637, “Application for Registration(For Certain Excise Tax Activities).” Theseregulations affect disregarded entities andthe owners and employees of disregardedentities with respect to the payment and re-porting of Federal employment taxes andthe reporting of wage payments. Theseregulations also affect disregarded entitiesand their owners in the payment and re-porting of certain Federal excise taxes andin registration and claims related to certainFederal excise taxes.

DATES: Effective Date: These regulationsare effective on August 16, 2007.

Applicability Dates: With respect toemployment taxes, these regulations apply

to wages paid on or after January 1, 2009.With respect to excise taxes, these regula-tions apply to liabilities imposed and ac-tions first required or permitted in periodsbeginning on or after January 1, 2008.

FOR FURTHER INFORMATIONCONTACT: John Richards at (202)622–6040 (on the employment tax pro-visions) or Susan Athy at (202) 622–3130(on the excise tax provisions) (not toll-freenumbers).


Background

This document contains amendmentsto 26 CFR parts 1 and 301. On October18, 2005, a notice of proposed rulemak-ing (REG–114371–05, 2005–2 C.B. 930)was published in the Federal Register(70 FR 60475) proposing to treat qual-ified subchapter S subsidiaries (QSubs)(under section 1361(b)(3)(B) of the In-ternal Revenue Code (Code)) and certainother single-owner eligible entities (un-der §§301.7701–1 through 301.7701–3 ofthe Procedure and Administrative Regu-lations) that currently are disregarded asentities separate from their owners (dis-regarded entities) as separate entities forpurposes of employment tax and relatedreporting requirements and for purposesof certain excise taxes reported on Forms720, 730, 2290, and 11–C; excise tax re-funds or payments claimed on Form 8849;and excise tax registrations on Form 637.Comments addressing employment taxeswere received from the public in responseto the notice of proposed rulemaking. Nocomments were received regarding theexcise tax provisions of the proposed reg-ulations. No public hearing was requestedor held. After consideration of all thecomments, the proposed regulations areadopted as revised by this Treasury deci-sion.

Summary of Comments and ChangesMade

As provided in the proposed regula-tions, the final regulations provide that adisregarded entity is treated as a separateentity for purposes of employment taxesand related reporting requirements. Thefinal regulations clarify that the separate

entity is treated as a corporation for pur-poses of employment taxes and related re-porting requirements. As provided in theproposed regulations, a disregarded entitycontinues to be disregarded for other Fed-eral tax purposes. The final regulationsclarify that an owner of a disregarded en-tity treated as a sole proprietorship is sub-ject to taxes under the Self-EmploymentContributions Act (SECA) (section 1401et. seq.). Additionally, the final regula-tions retain the example illustrating that anindividual owner of a disregarded entitycontinues to be treated as self-employedfor purposes of SECA taxes, and not as anemployee of a disregarded entity for em-ployment tax purposes.

Commentators suggested that the pro-posed regulations not be finalized, andthat Notice 99–6, 1999–1 C.B. 321, beretained. Notice 99–6 provides that em-ployment taxes and other employment taxobligations with respect to employees ofa disregarded entity may be satisfied inone of two ways: (1) calculation, report-ing, and payment of all employment taxobligations with respect to employees ofthe disregarded entity by its owner (asthough the employees of the disregardedentity are employed directly by the owner)and under the owner’s name and taxpayeridentification number; or (2) separate cal-culation, reporting, and payment of allemployment tax obligations by each statelaw entity with respect to its employeesunder its own name and taxpayer identifi-cation number.

Commentators stated that the regula-tions would increase administrative bur-den for taxpayers that currently chooseto pay and report employment taxes atthe owner level as permitted by Notice99–6. Commentators also suggested thatif the regulations were finalized, compli-cations could arise for states where stateemployment tax filings are required atthe owner level. No written commentswere received from any state. The IRSand the Treasury Department continueto believe that recognizing disregardedentities as employers for Federal employ-ment taxes will improve administration ofthe Federal tax laws and simplify Federaltax compliance with respect to reporting,payment, and collection of employmenttaxes. In addition, because most statesrecognize disregarded entities as employ-ers for reporting, payment, and collection

September 24, 2007 675 2007–39 I.R.B.

of state employment taxes, these regula-tions will more closely align Federal andstate reporting, payment and collectionof employment taxes. Accordingly, thiscomment is not adopted.

One commentator requested clari-fication of the applicability of section3306(c)(8) to services performed for adisregarded entity that is owned by an or-ganization described in section 501(c)(3).Section 3306(c)(8) provides that servicesperformed for an organization describedin section 501(c)(3) are excepted from thedefinition of employment for Federal Un-employment Tax Act (FUTA) purposes.Even though a disregarded entity ownedby a section 501(c)(3) organization willbe regarded for employment tax purposes,the disregarded entity will continue to beconsidered an unincorporated branch ordivision of the section 501(c)(3) organi-zation for other Federal tax purposes. Forexample, the disregarded entity will beconsidered an unincorporated branch ordivision of the section 501(c)(3) organi-zation for purposes of the organization’sannual information reporting requirementsunder section 6033. See Announcement99–102, 1999–2 C.B. 545. Because sec-tion 3306(c)(8) looks to the employer’sstatus for income tax purposes to establishthe basis for exemption from FUTA, adisregarded entity owned solely by a sec-tion 501(c)(3) organization is consideredexempt from tax under section 501(c)(3)for purposes of section 3306(c)(8). Thus,a disregarded entity owned solely by asection 501(c)(3) organization will not besubject to FUTA tax on wages it pays itsemployees.

One commentator requested clarifi-cation of the applicability of the backupwithholding provisions under section 3406to disregarded entities. Section 3406 re-quires the payor of certain “reportable pay-ments” to withhold from such payments atax at the rate of 28 percent. For instance,if the payee where required to do so doesnot provide a valid taxpayer identificationnumber (TIN) to the payor, the payor mustbackup withhold on reportable paymentsto the payee. Reportable payments arepayments that must be reported to a payeeon Form 1099, “U.S. Information Returnfor Calendar Year 1971,” such as certainpayments for services made in the courseof a trade or business. Wage payments arenot reportable payments however, and are

not subject to backup withholding undersection 3406. These regulations do not ap-ply to reportable payments under section3406. Because the owner of a disregardedentity other than a QSub is required tofile and furnish information returns withrespect to non-wage reportable paymentsand that requirement is not affected bythese regulations, the disregarded entityis not subject to the backup withholdingrequirements. Rather, the owner of thedisregarded entity is responsible for anybackup withholding that is required withrespect to reportable payments consid-ered made by the owner. Under section1361(b)(3)(E) disregarded entities that areQSubs are subject to information report-ing requirements on non-wage payments,unless the Secretary provides otherwise.These regulations do not address the in-formation reporting for QSubs.

Availability of IRS Documents

The IRS notice and announcement citedin this preamble are published in the Inter-nal Revenue Bulletin or Cumulative Bul-letin and are available at www.irs.gov.

Effective Date

The employment tax provisions of theseregulations apply to wages paid on or af-ter January 1, 2009. The notice of pro-posed rulemaking provided that these reg-ulations would become effective with re-spect to wages paid on January 1 follow-ing the year of publication of these fi-nal regulations in the Federal Register,which would have been January 1, 2008.However, in order to ensure that taxpay-ers have sufficient time to make any nec-essary changes to their systems in responseto these regulations, the IRS and the Trea-sury Department have determined that it isappropriate to delay the effective date ofthese regulations until January 1, 2009.

The IRS and the Treasury Departmentbelieve that the considerations that supporta January 1, 2009, effective date for theemployment tax provisions do not applyto the excise tax provisions. Thus, the ex-cise tax provisions of these regulations ap-ply to liabilities imposed and actions re-quired or permitted in periods beginningon or after January 1, 2008. For periodsbeginning before that date, the IRS willtreat payments made by a disregarded en-tity, or other actions taken by a disregarded

entity, with respect to the excise taxes af-fected by these regulations as having beenmade or taken by the sole owner of that en-tity. Thus, for such periods, the owner of adisregarded entity will be treated as satis-fying the owner’s obligations with respectto the excise taxes affected by these regu-lations, provided that those obligations aresatisfied either (1) by the owner itself or(2) by the disregarded entity on behalf ofthe owner.

Effect on Other Documents

Disregarded entities, and the ownersof such entities may continue to use theprocedures permitted by Notice 99–6 forwages paid prior to January 1, 2009. No-tice 99–6 provides that if the owner calcu-lates and pays all employment taxes andsatisfies all other employment tax obliga-tions with respect to employees of the dis-regarded entity under the owner’s nameand taxpayer identification number (as per-mitted under method (1) of Notice 99–6)for a return period that begins on or af-ter April 20, 1999, then the owner mustcontinue to use this method unless and un-til otherwise permitted by the Commis-sioner. However, Notice 99–6 is modifiedsuch that a taxpayer may switch to method(2) of Notice 99–6 with respect to wagespaid on or after August 16, 2007, and be-fore January 1, 2009, without seeking per-mission of the Commissioner. Taxpayerswho switch from method (1) to method (2)with respect to wages paid prior to January1, 2009, may consider wages paid by theowner to employees of the disregarded en-tity during the calendar year of the switchas having been paid by the disregarded en-tity for purposes of determining whetherwages paid to the disregarded entity’s em-ployees have reached the contribution andbenefit base as determined under section230 of the Social Security Act and for pur-poses of the wage base under section 3306.However, as provided in Notice 99–6, re-gardless of whether the owner uses method(1) or method (2), the owner is ultimatelyresponsible for employment tax liabilitiesand other employment tax responsibilitieswith respect to all wages paid prior to Jan-uary 1, 2009, to employees of the disre-garded entity.

Notice 99–6 is obsoleted as of January1, 2009.

2007–39 I.R.B. 676 September 24, 2007

Special Analyses

It has been determined that this Trea-sury decision is not a significant regula-tory action as defined in Executive Order12866. Therefore, a regulatory assessmentis not required. It also has been deter-mined that section 553(b) of the Admin-istrative Procedure Act (5 U.S.C. chapter5) does not apply to these regulations, andbecause the regulations do not impose acollection of information on small entities,the Regulatory Flexibility Act (5 U.S.C.chapter 6) does not apply. Pursuant to sec-tion 7805(f) of the Code, the proposed reg-ulations preceding these regulations weresubmitted to the Chief Counsel for Advo-cacy of the Small Business Administrationfor comment on their impact on small busi-ness.


The principal authors of these regula-tions are Susan Athy, Office of AssociateChief Counsel (Passthroughs and SpecialIndustries), and John Richards, Office ofAssociate Chief Counsel (Tax Exempt andGovernment Entities). However, otherpersonnel from the IRS and the TreasuryDepartment participated in their develop-ment.

* * * * *

Adoption of Amendments to theRegulations

Accordingly, 26 CFR parts 1 and 301are amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.34–1 is revised to read

as follows:

§1.34–1 Special rule for owners of certainbusiness entities.

Amounts payable under sections 6420,6421, and 6427 to a business entity thatis treated as separate from its owner un-der §1.1361–4(a)(8) (relating to certainqualified subchapter S subsidiaries) or§301.7701–2(c)(2)(v) of this chapter (re-lating to certain wholly-owned entities)

are, for purposes of section 34, treated aspayable to the owner of that entity.

§§1.34–2, 1.34–3, 1.34–4, 1.34–5, and1.34–6 [Removed]

Par. 3. Sections 1.34–2, 1.34–3,1.34–4, 1.34–5, and 1.34–6 are removed.

Par. 4. Section 1.1361–4 is amended asfollows:

1. In paragraph (a)(1) introductory text,the language “Except as otherwise pro-vided in paragraphs (a)(3) and (a)(6)” is re-moved, and the language “Except as other-wise provided in paragraphs (a)(3), (a)(6),(a)(7), and (a)(8)” is added in its place.

2. Paragraphs (a)(7) and (a)(8) areadded.

The additions read as follows:

§1.1361–4 Effect of QSub election.

(a) * * *(7) Treatment of QSubs for purposes

of employment taxes—(i) In general. AQSub is treated as a separate corporationfor purposes of Subtitle C — Employ-ment Taxes and Collection of Income Tax(Chapters 21, 22, 23, 23A, 24, and 25 ofthe Internal Revenue Code).

(ii) Effective/applicability date. Thisparagraph (a)(7) applies with respect towages paid on or after January 1, 2009.

(8) Treatment of QSubs for purposes ofcertain excise taxes—(i) In general. AQSub is treated as a separate corporationfor purposes of—

(A) Federal tax liabilities imposed byChapters 31, 32 (other than section 4181),33, 34, 35, 36 (other than section 4461),and 38 of the Internal Revenue Code, orany floor stocks tax imposed on articlessubject to any of these taxes;

(B) Collection of tax imposed by Chap-ter 33 of the Internal Revenue Code;

(C) Registration under sections 4101,4222, and 4412; and

(D) Claims of a credit (other than acredit under section 34), refund, or pay-ment related to a tax described in para-graph (a)(8)(i)(A) of this section or undersection 6426 or 6427.

(ii) Effective/applicability date. Thisparagraph (a)(8) applies to liabilities im-posed and actions first required or permit-ted in periods beginning on or after Jan-uary 1, 2008.

§1.1361–6 [Amended]

Par. 5. Section 1.1361–6 is amendedby removing the language “Exceptas provided in §§1.1361–4(a)(3)(iii),1.1361–4(a)(5)(i), and 1.1361–5(c)(2)”and by adding the language “Exceptas provided in §§1.1361–4(a)(3)(iii),1.1361–4(a)(5)(i), 1.1361–4(a)(6)(iii),1.1361–4(a)(7)(ii), 1.1361–4(a)(8)(ii), and1.1361–5(c)(2)” in its place.

PART 301—PROCEDURE ANDADMINISTRATION

Par. 6. The authority citation for part301 continues to read in part as follows:

Authority: 26 U.S.C. 7805 * * *Par. 7. Section 301.7701–2 is amended

as follows:1. A sentence is added at the end of

paragraph (a).2. Paragraph (c)(2)(i) is revised.3. Paragraphs (c)(2)(iv), (c)(2)(v),

(e)(5), and (e)(6) are added.The additions read as follows:

§301.7701–2 Business entities;definitions.

(a) * * * But see paragraphs (c)(2)(iv)and (v) of this section for special employ-ment and excise tax rules that apply to aneligible entity that is otherwise disregardedas an entity separate from its owner.

* * * * *(c) * * *(2) Wholly owned entities—(i) In gen-

eral. Except as otherwise provided in thisparagraph (c), a business entity that has asingle owner and is not a corporation underparagraph (b) of this section is disregardedas an entity separate from its owner.

* * * * *(iv) Special rule for employment tax

purposes—(A) In general. Paragraph(c)(2)(i) of this section (relating to certainwholly owned entities) does not apply totaxes imposed under Subtitle C — Em-ployment Taxes and Collection of IncomeTax (Chapters 21, 22, 23, 23A, 24, and 25of the Internal Revenue Code). Paragraph(c)(2)(i) of this section does apply to taxesimposed under Subtitle A, including Chap-ter 2 — Tax on Self-Employment Income.The owner of an entity that is treated inthe same manner as a sole proprietorship

September 24, 2007 677 2007–39 I.R.B.

under paragraph (a) of this section willbe subject to the tax on self-employmentincome.

(B) Treatment of entity. An entity thatis otherwise disregarded as an entity sep-arate from its owner but for paragraph(c)(2)(iv)(A) of this section is treated as acorporation with respect to taxes imposedunder Subtitle C — Employment Taxesand Collection of Income Tax (Chapters21, 22, 23, 23A, 24, and 25 of the InternalRevenue Code).

(C) Example. The following exampleillustrates the application of paragraph(c)(2)(iv) of this section:

Example. (i) LLCA is an eligible entity ownedby individual A and is generally disregarded as anentity separate from its owner for Federal tax pur-poses. However, LLCA is treated as an entity sep-arate from its owner for purposes of subtitle C of theInternal Revenue Code. LLCA has employees andpays wages as defined in sections 3121(a), 3306(b),and 3401(a).

(ii) LLCA is subject to the provisions of subtitleC of the Internal Revenue Code and related pro-visions under 26 CFR subchapter C, EmploymentTaxes and Collection of Income Tax at Source, parts31 through 39. Accordingly, LLCA is required toperform such acts as are required of an employerunder those provisions of the Internal Revenue Codeand regulations thereunder that apply. All provisionsof law (including penalties) and the regulations pre-scribed in pursuance of law applicable to employersin respect of such acts are applicable to LLCA. Thus,for example, LLCA is liable for income tax with-holding, Federal Insurance Contributions Act (FICA)taxes, and Federal Unemployment Tax Act (FUTA)taxes. See sections 3402 and 3403 (relating to in-come tax withholding); 3102(b) and 3111 (relatingto FICA taxes), and 3301 (relating to FUTA taxes).In addition, LLCA must file under its name and EINthe applicable forms in the 94X series, for example,Form 941, “Employer’s QUARTERLY Federal TaxReturn,” Form 940, “Employer’s Annual FederalUnemployment(FUTA) Tax Return;” file with the So-cial Security Administration and furnish to LLCA’semployees statements on Forms W–2, “Wage andTax Statement;” and make timely employmenttax deposits. See §§31.6011(a)–1, 31.6011(a)–3,31.6051–1, 31.6051–2, and 31.6302–1 of this chap-ter.

(iii) A is self-employed for purposes of subtitle A,chapter 2, Tax on Self-Employment Income, of the

Internal Revenue Code. Thus, A is subject to tax un-der section 1401 on A’s net earnings from self-em-ployment with respect to LLCA’s activities. A is notan employee of LLCA for purposes of subtitle C ofthe Internal Revenue Code. Because LLCA is treatedas a sole proprietorship of A for income tax purposes,A is entitled to deduct trade or business expensespaid or incurred with respect to activities carried onthrough LLCA, including the employer’s share ofemployment taxes imposed under sections 3111 and3301, on A’s Form 1040, Schedule C, “Profit or LossFrom Business (Sole Proprietorship).”

(v) Special rule for certain excise taxpurposes—(A) In general. Paragraph(c)(2)(i) of this section (relating to certainwholly owned entities) does not apply forpurposes of—

(1) Federal tax liabilities imposed byChapters 31, 32 (other than section 4181),33, 34, 35, 36 (other than section 4461),and 38 of the Internal Revenue Code, orany floor stocks tax imposed on articlessubject to any of these taxes;

(2) Collection of tax imposed by Chap-ter 33 of the Internal Revenue Code;

(3) Registration under sections 4101,4222, and 4412; and

(4) Claims of a credit (other than acredit under section 34), refund, or pay-ment related to a tax described in para-graph (c)(2)(v)(A)(1) of this section or un-der section 6426 or 6427.

(B) Example. The following exampleillustrates the provisions of this paragraph(c)(2)(v):

Example. (i) LLCB is an eligible entity that hasa single owner, B. LLCB is generally disregarded asan entity separate from its owner. However, underparagraph (c)(2)(v) of this section, LLCB is treated asan entity separate from its owner for certain purposesrelating to excise taxes.

(ii) LLCB mines coal from a coal mine locatedin the United States. Section 4121 of chapter 32 ofthe Internal Revenue Code imposes a tax on the pro-ducer’s sale of such coal. Section 48.4121–1(a) ofthis chapter defines a “producer” generally as the per-son in whom is vested ownership of the coal understate law immediately after the coal is severed fromthe ground. LLCB is the person that owns the coalunder state law immediately after it is severed fromthe ground. Under paragraph (c)(2)(v)(A)(1) of this

section, LLCB is the producer of the coal and is liablefor tax on its sale of such coal under chapter 32 of theInternal Revenue Code. LLCB must report and paytax on Form 720, “Quarterly Federal Excise Tax Re-turn,” under its own name and taxpayer identificationnumber.

(iii) LLCB uses undyed diesel fuel in an earth-mover that is not registered or required to be reg-istered for highway use. Such use is an off-high-way business use of the fuel. Under section 6427(l),the ultimate purchaser is allowed to claim an incometax credit or payment related to the tax imposed ondiesel fuel used in an off-highway business use. Un-der paragraph (c)(2)(v) of this section, for purposes ofthe credit or payment allowed under section 6427(l),LLCB is the person that could claim the amount onits Form 720 or on a Form 8849, “Claim for Re-fund of Excise Taxes.” Alternatively, if LLCB did notclaim a payment during the time prescribed in section6427(i)(2) for making a claim under section 6427,§1.34–1 of this chapter provides that B, the owner ofLLCB, could claim the income tax credit allowed un-der section 34 for the nontaxable use of diesel fuel byLLCB.

* * * * *(e) * * *(5) Paragraph (c)(2)(iv) of this section

applies with respect to wages paid on orafter January 1, 2009.

(6) Paragraph (c)(2)(v) of this sectionapplies to liabilities imposed and actionsfirst required or permitted in periods be-ginning on or after January 1, 2008.


Approved July 25, 2007.

Eric Solomon,Assistant Secretary of

the Treasury (Tax Policy).

(Filed by the Office of the Federal Register on August 15,2007, 8:45 a.m., and published in the issue of the FederalRegister for August 16, 2007, 72 F.R. 45891)

2007–39 I.R.B. 678 September 24, 2007

Part III. Administrative, Procedural, and MiscellaneousWeighted Average InterestRates Update

Notice 2007–75

This notice provides guidance as to thecorporate bond weighted average interestrate and the permissible range of interestrates specified under § 412(b)(5)(B)(ii)(II)of the Internal Revenue Code. In addi-tion, it provides guidance as to the interestrate on 30-year Treasury securities under§ 417(e)(3)(A)(ii)(II).

CORPORATE BOND WEIGHTEDAVERAGE INTEREST RATE

Sections 412(b)(5)(B)(ii) and412(l)(7)(C)(i), as amended by the Pension

Funding Equity Act of 2004 and by thePension Protection Act of 2006, providethat the interest rates used to calculate cur-rent liability and to determine the requiredcontribution under § 412(l) for plan yearsbeginning in 2004 through 2007 must bewithin a permissible range based on theweighted average of the rates of interest onamounts invested conservatively in longterm investment grade corporate bondsduring the 4-year period ending on the lastday before the beginning of the plan year.

Notice 2004–34, 2004–1 C.B. 848, pro-vides guidelines for determining the cor-porate bond weighted average interest rateand the resulting permissible range of in-terest rates used to calculate current liabil-ity. That notice establishes that the corpo-

rate bond weighted average is based on themonthly composite corporate bond rate de-rived from designated corporate bond in-dices. The methodology for determiningthe monthly composite corporate bond rateas set forth in Notice 2004–34 continues toapply in determining that rate. See Notice2006–75, 2006–36 I.R.B. 366.

The composite corporate bond rate forAugust 2007 is 6.33 percent. Pursuantto Notice 2004–34, the Service has de-termined this rate as the average of themonthly yields for the included corporatebond indices for that month.

The following corporate bond weightedaverage interest rate was determined forplan years beginning in the month shownbelow.

For Plan YearsCorporate

Bond 90% to 100%Beginning in: Weighted Permissible

Month Year Average Range

September 2007 5.86 5.27 to 5.86

30-YEAR TREASURY SECURITIESINTEREST RATE

Section 417(e)(3)(A)(ii)(II) definesthe applicable interest rate, which mustbe used for purposes of determining theminimum present value of a participant’sbenefit under § 417(e)(1) and (2), as theannual rate of interest on 30-year Treasurysecurities for the month before the dateof distribution or such other time as theSecretary may by regulations prescribe.Section 1.417(e)–1(d)(3) of the IncomeTax Regulations provides that the applica-ble interest rate for a month is the annualinterest rate on 30-year Treasury securi-ties as specified by the Commissioner forthat month in revenue rulings, notices orother guidance published in the InternalRevenue Bulletin.

The rate of interest on 30-year Treasurysecurities for August 2007 is 4.93 percent.The Service has determined this rate as theaverage of the yield on the 30-year Trea-sury bond maturing in February 2037 de-termined each day through August 8, 2007,and the yield on the 30-year Treasury bondmaturing in May 2037 determined eachday for the balance of the month.


The principal authors of this notice arePaul Stern and Tony Montanaro of the Em-ployee Plans, Tax Exempt and Govern-ment Entities Division. For further infor-mation regarding this notice, please con-tact the Employee Plans’ taxpayer assis-tance telephone service at 877–829–5500(a toll-free number), between the hours of8:30 a.m. and 4:30 p.m. Eastern time,Monday through Friday. Mr. Stern may bereached at 202–283–9703. Mr. Montanaromay be reached at 202–283–9714. Thetelephone numbers in the preceding sen-tences are not toll-free.

26 CFR 601.602: Tax forms and instructions.(Also: Part I, § 179.)

Rev. Proc. 2007–60

SECTION 1. PURPOSE

This revenue procedure corrects the in-flation adjusted amounts set forth in Rev.Proc. 2006–53, 2006–48 I.R.B. 996, that

apply to taxpayers who elect to expensecertain depreciable assets under § 179 ofthe Internal Revenue Code. This correc-tion reflects statutory changes enacted sub-sequent to the publication of Rev. Proc.2006–53.

SECTION 2. BACKGROUND

Prior to the enactment of the SmallBusiness and Work Opportunity TaxAct of 2007, Pub. L. No. 110–28, 121Stat. 190 (2007) (the Act), § 179(b)(1)prescribed a $100,000 limitation (the$100,000 amount) on the aggregate costof section 179 property that could betreated as an expense for any taxableyear beginning after 2002 and before2010. For those same taxable years, sec-tion 179(b)(2) provided that the $100,000amount is reduced by the amount by whichthe cost of section 179 property placed inservice during the taxable year exceeds$400,000 (the $400,000 amount). Boththe $100,000 amount and the $400,000amount were adjusted for inflation annu-ally. For taxable years beginning in 2007,section 3.19 of Rev. Proc. 2006–53 pro-vides that the $100,000 amount and the

September 24, 2007 679 2007–39 I.R.B.

$400,000 amount, adjusted for inflation,are $112,000 and $450,000, respectively.

Section 8212 of the Act changesthe $100,000 amount and the $400,000amount to $125,000 (the $125,000amount) and $500,000 (the $500,000amount), respectively, for taxable yearsbeginning in 2007 through 2010. Sec-tion 8212 of the Act also provides thatthe $125,000 amount and the $500,000amount will be adjusted for inflation fortaxable years beginning after 2007 andbefore 2011.

SECTION 3. MODIFICATION OFSECTION 3.19 OF REV. PROC. 2006–53

To reflect the statutory changes made tosection 179 by § 8212 of the Act, section3.19 of Rev. Proc. 2006–53 is modified toread as follows:

.19 Election to Expense Certain Depre-ciable Assets. For taxable years begin-

ning in 2007, under § 179(b)(1) the aggre-gate cost of any § 179 property a taxpayermay elect to treat as an expense cannotexceed $125,000. Under § 179(b)(2) the$125,000 limitation is reduced (but not be-low zero) by the amount by which the costof § 179 property placed in service duringthe 2007 taxable year exceeds $500,000.For taxable years beginning after 2007 andbefore 2011, the $125,000 amount under§ 179(b)(1) and $500,000 amount under§ 179(b)(2) will be adjusted for inflation.

SECTION 4. EFFECT ON OTHERDOCUMENTS

Section 3.19 of Rev. Proc. 2006–53 ismodified and superseded.

SECTION 5. EFFECTIVE DATE

This revenue procedure is effective fortaxable years beginning in 2007.

SECTION 6. DRAFTINGINFORMATION

The principal author of this revenueprocedure is Winston H. Douglas of theOffice of Associate Chief Counsel (In-come Tax & Accounting). For furtherinformation regarding this revenue proce-dure, contact Winston H. Douglas at (202)622–4930 (not a toll-free call).

2007–39 I.R.B. 680 September 24, 2007

Part IV. Items of General InterestWithdrawal of Prior Notices ofProposed Rulemaking, Noticeof Proposed Rulemaking andNotice of Public Hearing

Employee Benefits —Cafeteria Plans

REG–142695–05


ACTION: Withdrawal of prior notices ofproposed rulemaking, notice of proposedrulemaking and notice of public hearing.

SUMMARY: This document contains newproposed regulations providing guidanceon cafeteria plans. This document alsowithdraws the notices of proposed rule-making relating to cafeteria plans undersection 125 that were published on May 7,1984, December 31, 1984, March 7, 1989,November 7, 1997 and March 23, 2000. Ingeneral, these proposed regulations wouldaffect employers that sponsor a cafeteriaplan, employees that participate in a cafe-teria plan, and third-party cafeteria planadministrators.

DATES: Written or electronic commentsmust be received by November 5, 2007.Outlines of topics to be discussed at thehearing scheduled for November 15, 2007,at 10 a.m., must be received by October 25,2007.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–142695–05),room 5203, Internal Revenue Service,P.O. Box 7604, Ben Franklin Sta-tion, Washington, DC 20044. Submis-sions may be hand delivered Mondaythrough Friday between the hours of8 a.m. and 4 p.m. to CC:PA:LPD:PR(REG–142695–05), Courier’s Desk, In-ternal Revenue Service, 1111 ConstitutionAvenue, NW, Washington, DC, or sentelectronically via the Federal eRulemak-ing Portal at www.regulations.gov (IRSREG–142695–05). The public hearingwill be held at the IRS Auditorium, Inter-nal Revenue Building, 1111 ConstitutionAvenue, NW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposedregulations, Mireille T. Khoury at (202)622–6080; concerning submissions ofcomments, the hearing, and/or to be placedon the building access list to attend thehearing, Oluwafunmilayo Taylor of thePublications and Regulations Branch at(202) 622–7180 (not toll-free numbers).


Paperwork Reduction Act

The collections of information con-tained in this notice of proposed rulemak-ing have been submitted to the Office ofManagement and Budget for review inaccordance with the Paperwork Reduc-tion Act of 1995 (44 U.S.C. 3507(d)).Comments on the collections of infor-mation should be sent to the Office ofManagement and Budget, Attn: DeskOfficer for the Department of Treasury,Office of Information and RegulatoryAffairs, Washington, DC 20503, withcopies to the Internal Revenue Service,Attn: IRS Reports Clearance Officer,SE:W:CAR:MP:T:T:SP, Washington, DC20224. Comments on the collections ofinformation should be received by Octo-ber 5, 2007. Comments are specificallyrequested concerning:

Whether the proposed collections of in-formation is necessary for the proper per-formance of the functions of the InternalRevenue Service, including whether theinformation will have practical utility;

The accuracy of the estimated burdenassociated with the proposed collection ofinformation;

How the quality, utility, and clarity ofthe information to be collected may be en-hanced;

How the burden of complying with theproposed collections of information maybe minimized, including through the appli-cation of automatic collection techniquesor other forms of information technology;and

Estimates of the capital or start-up costsand costs of operation, maintenance, andpurchase of service to provide information.

The collection of information in thisproposed regulation is in §1.125–2 (cafete-ria plan elections); §1.125–6(b)–(g) (sub-

stantiation of expenses), and §1.125–7(cafeteria plan nondiscrimination rules).This information is required to file em-ployment tax returns and Forms W–2. Thecollection of information is voluntary toobtain a benefit. The likely respondentsare Federal, state or local governments,business or other for-profit institutions,nonprofit institutions, and small busi-nesses or organizations.

Estimated total annual reporting bur-den: 34,000,000 hours.

Estimated average annual burden perrespondent: 5 hours.

Estimated annual frequency of re-sponses: once.

An agency may not conduct or sponsor,and a person is not required to respond to, acollection of information unless it displaysa valid control number assigned by the Of-fice of Management and Budget.

Books or records relating to a collectionof information must be retained as longas their contents may become material inthe administration of any internal revenuelaw. Generally, tax returns and tax returninformation are confidential, as requiredby 26 U.S.C. 6103.

Background

This document contains proposed In-come Tax Regulations (26 CFR Part 1)under section 125 of the Internal RevenueCode (Code). On May 7, 1984, Decem-ber 31, 1984, March 7, 1989, November7, 1997, and March 23, 2000, the IRSand Treasury Department published pro-posed amendments to 26 CFR Part 1under section 125 in the Federal Reg-ister (EE–16–79, 1984–1 C.B. 563 [49FR 19321], EE–16–79, 1985–1 C.B. 603[49 FR 50733], EE–130–86, 1989–1 C.B.944 [54 FR 9460], REG–243025–96,1997–2 C.B. 626 [62 FR 60196] andREG–117162–99, 2000–1 C.B. 871 [65FR 15587]). These 1984, 1989, 1997and 2000 proposed regulations are herebywithdrawn. Also, the temporary regula-tions under section 125 that were pub-lished on February 4, 1986 in the FederalRegister (T.D. 8073, 1986–1 C.B. 45[51 FR 4318]) are being withdrawn in aseparate document. The new proposedregulations that are published in this doc-ument replace those proposed regulations.

September 24, 2007 681 2007–39 I.R.B.

Explanation of Provisions

Overview

The new proposed regulations areorganized as follows: general rules onqualified and nonqualified benefits incafeteria plans (new proposed §1.125–1),general rules on elections (new proposed§1.125–2), general rules on flexiblespending arrangements (new proposed§1.125–5), general rules on substantia-tion of expenses for qualified benefits(new proposed §1.125–6) and nondiscrim-ination rules (new proposed §1.125–7).The new proposed regulations, new Pro-posed §§1.125–1, 1.125–2, 1.125–5,1.125–6 and §1.125–7, consolidate andrestate Proposed §1.125–1 (1984, 1997,2000), §1.125–2 (1989, 1997, 2000) and§1.125–2T (1986). Unless otherwise in-dicated, references to “new proposed reg-ulations” or “these proposed regulations”mean the proposed section 125 regulationsbeing published in this document.

The new proposed regulations reflectchanges in tax law since the prior reg-ulations were proposed, including: thechange in the definition of dependent(section 152) and the addition of the fol-lowing as qualified benefits: adoptionassistance (section 137), additional de-ferred compensation benefits describedin section 125(d)(1)(B), (C) and (D),Health Savings Accounts (HSAs) (sec-tions 223, 125(d)(2)(D) and 4980G), andqualified HSA distributions from healthFSAs (section 106(e)). Other changesinclude the prohibition against long-termcare insurance and long-term care services(section 125(f)) and the addition of thekey employee concentration test in section125(b)(2).

The prior proposed regulations,§§1.125–1 and 1.125–2, provide the basicframework and requirements for cafeteriaplans and elections under cafeteria plans.The prior proposed regulations also out-lined the most significant rules for benefitsunder a health flexible spending arrange-ment (health FSA) offered by a cafeteriaplan — the requirement that the maxi-mum reimbursement be available at alltimes during the coverage period (the uni-form coverage rule), the requirement of a12-month period of coverage, the require-ment that the health FSA only reimbursemedical expenses, the requirement that

all medical expenses be substantiated bya third party before reimbursement, therequirement that expenses be incurredduring the period of coverage, and theprohibition against deferral of compensa-tion (including the use-or-lose rule). Theprior proposed regulations also providedguidelines for dependent care FSAs, andthe application of section 125 to paid va-cation days offered under a cafeteria plan.These remain substantially unchanged inthe new proposed regulations, with certainclarifications. Finally, the prior proposedregulations included a number of Q & Asaddressing transitional issues relating tothe enactment of section 125, as well asthe application of the now-repealed sec-tion 89 (special nondiscrimination ruleswith respect to certain employee benefitplans). These provisions are omitted fromthe new proposed regulations.

I. New Proposed §1.125–1—Qualified andnonqualified benefits in cafeteria plans

Section 125 exclusive noninclusion rule

Section 125 provides that, except in thecase of certain discriminatory benefits, noamount shall be included in the gross in-come of a participant in a cafeteria plan(as defined in section 125(d)) solely be-cause, under the plan, the participant maychoose among the benefits of the plan. Thenew proposed regulations clarify and am-plify the general rule in the prior proposedregulations that section 125 is the exclu-sive means by which an employer can offeremployees a choice between taxable andnontaxable benefits without the choice it-self resulting in inclusion in gross incomeby the employees. When employees mayelect between taxable and nontaxable ben-efits, this election results in gross incometo employees, unless a specific InternalRevenue Code (Code) section (such as sec-tion 125) intervenes to prevent gross in-come inclusion. Thus, except for an elec-tion made through a cafeteria plan that sat-isfies section 125 or another specific Codesection (such as section 132(f)(4)), any op-portunity to elect among taxable and non-taxable benefits results in inclusion of thetaxable benefit regardless of what benefitis elected and when the election is made.This interpretation of section 125 is con-sistent with the legislative history of sec-tion 125. The legislative history begins

with the interim ERISA rules for cafeteriaplans:

Under ... ERISA, an employer con-tribution made before January 1, 1977,to a cafeteria plan in existence on June27, 1974, is required to be included inan employees’ gross income only to theextent that the employee actually electstaxable benefits. In the case of a plannot in existence on June 27, 1974, theemployer contribution is required to beincluded in an employee’s gross incometo the extent the employee could haveelected taxable benefits.

S. Rep. No. 1263, 95th Cong., 2dSess. 74 (1978), reprinted in 1978U.S.C.C.A.N. 6837; H.R. Rep. No.1445, 95th Cong., 2d Sess. 63 (1978);H.R. Conf. Rep. No. 1800, 95th Cong.,2d Sess. 206 (1978).

The legislative history also provides:[G]enerally, employer contributions

under a written cafeteria plan whichpermits employees to elect between tax-able and nontaxable benefits are ex-cluded from the gross income of anemployee to the extent that nontaxablebenefits are elected.

S. Rep. No. 1263, 95th Cong., 2dSess. 75 (1978), reprinted in 1978U.S.C.C.A.N. 6838; H.R. Rep. No.1445, 95th Cong., 2d Sess. 63 (1978).See also H.R. Conf. Rep. No. 1800,95th Cong., 2d Sess. 206 (1978).

The legislative history to the 1984amendments to section 125 continues:

The cafeteria plan rules of the Codeprovide that a participant in a nondis-criminatory cafeteria plan will not betreated as having received a taxablebenefit offered under the plan solelybecause the participant has the op-portunity, before the benefit becomesavailable, to choose among the taxableand nontaxable benefits under the plan.

H.R. Conf. Rep. No. 861, 98th Cong.,2d Sess. 1173 (1984), reprinted in1984 U.S.C.C.A.N. 1861. See alsoH.R. Conf. Rep. No. 736, 104th

Cong., 2d Sess. 295, reprinted in 1996U.S.C.C.A.N. 2108.The new proposed regulations provide

that unless a plan satisfies the requirements

2007–39 I.R.B. 682 September 24, 2007

of section 125 and the regulations, the planis not a cafeteria plan. Reasons that aplan would fail to satisfy the section 125requirements include: offering nonquali-fied benefits; not offering an election be-tween at least one permitted taxable bene-fit and at least one qualified benefit; defer-ring compensation; failing to comply withthe uniform coverage rule or use-or-loserule; allowing employees to revoke elec-tions or make new elections during a planyear, except as provided in §1.125–4; fail-ing to comply with substantiation require-ments; paying or reimbursing expenses in-curred for qualified benefits before the ef-fective date of the cafeteria plan or beforea period of coverage; allocating experiencegains (forfeitures) other than as expresslyallowed in the new proposed regulations;and failing to comply with grace periodrules.

Definition of a cafeteria plan

The new proposed regulations providethat a cafeteria plan is a separate writtenplan that complies with the requirementsof section 125 and the regulations, that ismaintained by an employer for employeesand that is operated in compliance with therequirements of section 125 and the reg-ulations. Participants in a cafeteria planmust be permitted to choose among at leastone permitted taxable benefit (for exam-ple, cash, including salary reduction) andat least one qualified benefit. A plan offer-ing only elections among nontaxable ben-efits is not a cafeteria plan. Also, a planoffering only elections among taxable ben-efits is not a cafeteria plan. See Rev. Rul.2002–27, 2002–1 C.B. 925, Situation 2,see §601.601(d)(2)(ii)(b). Finally, a cafe-teria plan must not provide for deferral ofcompensation, except as specifically per-mitted in section 125(d)(2)(B), (C), or (D).

Written plan

Section 125(d)(1) requires that a cafe-teria plan be in writing. The cafeteriaplan must be operated in accordance withthe written plan terms. The new pro-posed regulations require that the writtenplan specifically describe all benefits, setforth the rules for eligibility to participateand the procedure for making elections,provide that all elections are irrevocable(except to the extend that the plan in-cludes the optional change in status rules

in §1.125–4), and state how employer con-tributions may be made under the plan (forexample, salary reduction or nonelectiveemployer contributions), the maximumamount of elective contributions, and theplan year. If the plan includes a flexiblespending arrangement (FSA), the writtenplan must include provisions comply-ing with the uniform coverage rule andthe use-or-lose rule. Because section125(d)(1)(A) states that a cafeteria planis a written plan under which “all partic-ipants are employees,” the new proposedregulations require that the written cafete-ria plan specify that only employees mayparticipate in the cafeteria plan. The newproposed regulations also require that allprovisions of the written plan apply uni-formly to all participants.

Individuals who may participate in acafeteria plan

All participants in a cafeteria plan mustbe employees. See section 125(d)(1)(A).These proposed regulations provide thatemployees include common law employ-ees, leased employees described in section414(n), and full-time life insurance sales-men (as defined in section 7701(a)(20)).These proposed regulations further pro-vide that former employees (includinglaid-off employees and retired employees)may participate in a plan, but a plan maynot be maintained predominantly for for-mer employees. See Rev. Rul. 82–196,1982–2 C.B. 53; Rev. Rul. 85–121,1985–2 C.B. 57, see §601.601(d)(2)(ii)(b).All employees who are treated as em-ployed by a single employer under section414(b), (c) or (m) are treated as employedby a single employer for purposes ofsection 125. See section 125(g)(4). Aparticipant’s spouse or dependents mayreceive benefits through a cafeteria planalthough they cannot participate in thecafeteria plan.

Self-employed individuals are nottreated as employees for purposes ofsection 125. Accordingly, the new pro-posed regulations make clear that soleproprietors, partners, and directors of cor-porations are not employees and may notparticipate in a cafeteria plan. In addition,the new proposed regulations clarify that2-percent shareholders of an S corporationare not employees for purposes of section125. The new proposed regulations pro-

vide rules for dual status individuals andindividuals moving between employee andnon-employee status. A self-employed in-dividual may, however, sponsor a cafeteriaplan for his or her employees.

Election between taxable and nontaxablebenefits

The new proposed regulations requirethat a cafeteria plan offer employeesan election among only permitted tax-able benefits (including cash) and qual-ified nontaxable benefits. See section125(d)(1)(B). For purposes of section 125,cash means cash from current compensa-tion (including salary reduction), paymentfor annual leave, sick leave, or other paidtime off, severance pay, property, andcertain after-tax employee contributions.Distributions from qualified retirementplans are not cash or taxable benefits forpurposes of section 125. See Rev. Rul.2003–62, 2003–1 C.B. 1034 (distributionsto former employees from a qualifiedemployees’ trust, applied to pay healthinsurance premiums, are includible informer employees’ gross income undersection 402), see §601.601(d)(2)(ii)(b).

Qualified benefits

In general, in order for a benefit to bea qualified benefit for purposes of sec-tion 125, the benefit must be excludiblefrom employees’ gross income under aspecific provision of the Code and mustnot defer compensation, except as specif-ically allowed in section 125(d)(2)(B),(C) or (D). Examples of qualified ben-efits include the following: group-termlife insurance on the life of an employee(section 79); employer-provided acci-dent and health plans, including healthflexible spending arrangements, and acci-dental death and dismemberment policies(sections 106 and 105(b)); a dependentcare assistance program (section 129);an adoption assistance program (section137); contributions to a section 401(k)plan; contributions to certain plans main-tained by educational organizations, andcontributions to HSAs. Section 125(f),(d)(2)(B), (C), (D). See Notice 97–9,1997–1 C.B. 365 (adoption assistance),see §601.601(d)(2)(ii)(b); Notice 2004–2,2004–1 C.B. 269, Q & A–33 (HSAs), see§601.601(d)(2)(ii)(b). A cafeteria planmay also offer long-term and short-term

September 24, 2007 683 2007–39 I.R.B.

disability coverage as a qualified benefit(see section 106). However, see paragraph(q) in §1.125–1 for nonqualified benefits.

Group-term life insurance

An employer may provide group-termlife insurance through a combination ofmethods. Generally, under section 79(a),the cost of $50,000 or less of group-termlife insurance on the life of an employeeprovided under a policy (or policies) car-ried directly or indirectly by an employeris excludible from the employee’s grossincome. (Special rules apply to key em-ployees if the group-term life insuranceplan does not satisfy the nondiscrimina-tion rules in section 79(d)). However, ifthe group-term life insurance provided toan employee by an employer or employ-ers exceeds $50,000 (taking into accountall coverage provided both through a cafe-teria plan and outside a cafeteria plan),the cost of coverage exceeding coverageof $50,000 is includible in the employee’sgross income. For this purpose, the costof group-term life insurance is shown in§1.79–3(d)(2), Table I (Table I). The Ta-ble I cost of the excess group-term life in-surance (minus all after-tax contributionsby the employee for group-term life insur-ance coverage) is includible in each cov-ered employee’s gross income. The newproposed regulations provide that the costof group-term life insurance on the life ofan employee, that either is less than orequal to the amount excludible from grossincome under section 79(a) or providescoverage in excess of that amount, but notcombined with any permanent benefit, is aqualified benefit that may be offered in acafeteria plan. The new proposed regula-tions also provide that the entire amount ofsalary reduction and employer flex-creditsfor group-term life insurance coverage onthe life of an employee is excludible froman employee’s gross income.

The rule in the new proposed regula-tions differs from Notice 89–110, 1989–2C.B. 447, see §601.601(d)(2)(ii)(b). No-tice 89–110 provides that an employeeincludes in gross income the greater ofthe Table I cost of group-term life in-surance coverage exceeding $50,000 orthe employee’s salary reduction and em-ployer flex-credits for excess group-termlife insurance coverage. The new pro-posed regulations provide instead that

the employee includes in gross incomethe Table I cost of the excess coverage(minus all after-tax contributions by theemployee for group-term life insurancecoverage) and that the entire amount ofsalary reduction and employer flex-creditsfor group-term life insurance coverage onthe life of the employee is excludible fromthe employee’s gross income. As notedin this preamble, taxpayers may rely onthe new proposed regulations for guidancepending the issuance of final regulations.

Employer-provided accident and healthplan

Coverage under an employer-providedaccident and health plan that satisfies therequirements of section 105(b) may beprovided as a qualified benefit througha cafeteria plan and is excludible fromemployees’ gross income. Section 106;§1.106–1. The nondiscrimination rulesunder section 105(h) apply to self-insuredmedical reimbursement arrangements (in-cluding health FSAs).

The new proposed regulations specif-ically permit a cafeteria plan (but not ahealth FSA) to pay or reimburse substan-tiated individual accident and health insur-ance premiums. See Rev. Rul. 61–146,1961–2 C.B. 25, see §601.601(d)(2)(ii)(b).In addition, a cafeteria plan may providefor payment of COBRA premiums for anemployee.

For employer-provided accident andhealth plans and medical reimbursementplans, the definition of dependents is thedefinition in section 105(b) as amendedby the Working Families Tax Relief Actof 2004 (WFTRA), Public Law 108–311,section 207(9) (118 Stat. 1166) (thatis, a dependent as defined in section152, determined without regard to sec-tion 152(b)(1), (b)(2), or (d)(1)(B)). SeeNotice 2004–79, 2004–2 C.B. 898, see§601.601(d)(2)(ii)(b). For purposes of theexclusion from employees’ gross incomefor accident and health plans and for med-ical reimbursement under sections 105(b)and 106, the spouse or dependent of aformer employee (including a retired em-ployee or a laid-off employee) or of a de-ceased employee is treated as a spouse ordependent. See Rev. Rul. 82–196, 1982–2C.B. 53; Rev. Rul. 85–121, 1985–2 C.B.57, see §601.601(d)(2)(ii)(b).

Dependent care assistance programs andadoption assistance programs

If the requirements of section 129 aresatisfied, up to $5,000 of employer-pro-vided assistance for amounts paid or in-curred by employees for dependent careis excludible from employees’ gross in-come. The new proposed regulations out-line the general requirements for providingdependent care assistance programs andadoption assistance programs under sec-tion 137 through a cafeteria plan. See No-tice 97–9, 1997–1 C.B. 365, section II, see§601.601(d)(2)(ii)(b).

Cafeteria plan year

The new proposed regulations requirethat a cafeteria plan year must be 12 con-secutive months and must be set out inthe written cafeteria plan. A short planyear (or a change in plan year resulting ina short plan year) is permitted only for avalid business purpose. A change in planyear resulting in a short plan year, for otherthan a valid business purpose, is disre-garded. If a principal purpose of a changein plan year is to circumvent the rules ofsection 125, the change in plan year is in-effective.

No deferral of compensation

Qualified benefits must be current ben-efits. In general, a cafeteria plan may notoffer benefits that defer compensation oroperate to defer compensation. Section125(d)(2)(A). In general, benefits may notbe carried over to a later plan year or usedin one plan year to purchase benefits tobe provided in a later plan year. For ex-ample, life insurance with a cash valuebuild-up or group-term life insurance witha permanent benefit (within the meaning of§1.79–0) defers the receipt of compensa-tion and thus is not a qualified benefit.

The new proposed regulations clarifywhether certain benefits and plan adminis-tration practices defer compensation. Forexample, the regulations permit an acci-dent and health insurance policy to pro-vide certain benefit features that apply formore than one plan year, such as reason-able lifetime limits on benefits, level pre-miums, premium waiver during disabil-ity, guaranteed renewability of coverage,coverage for specified accidental injury orspecific diseases, and the payment of a

2007–39 I.R.B. 684 September 24, 2007

fixed amount per day for hospitalization.But these insurance policies must not pro-vide an investment fund or cash value topay premiums, and no part of the premiummay be held in a separate account for anybeneficiary. The new proposed regulationsalso provide that the following benefitsand practices do not defer compensation:a long-term disability policy paying bene-fits over more than one plan year; reason-able premium rebates or policy dividends;certain two-year lock-in vision and den-tal policies; certain advance payments fororthodontia; salary reduction contributionsin the last month of a plan year used to payaccident and health insurance premiumsfor the first month of the following planyear; reimbursement of section 213(d) ex-penses for durable medical equipment; andallocation of experience gains (forfeitures)among participants.

Paid time off

Under the prior proposed regulations,permitted taxable benefits included vari-ous forms of paid leave. Since the priorproposed regulations were issued, manyemployers have recharacterized and com-bined vacation days, sick leave and per-sonal days into a single category of “paidtime off.” The new proposed regulationsuse the term “paid time off” to refer to va-cation days and other types of paid leave.The new proposed regulations contain thesame ordering rule for elective and non-elective paid time off as set forth in Prop.§1.125–1, Q & A–7 (1984). A plan offer-ing an election solely between paid timeoff and taxable benefits is not a cafeteriaplan.

Grace period

The new proposed regulations allowa written cafeteria plan to provide an op-tional grace period immediately followingthe end of each plan year, extending theperiod for incurring expenses for quali-fied benefits. A grace period may applyto one or more qualified benefits (forexample, health FSA or dependent careassistance program) but in no event doesit apply to paid time off or contributionsto section 401(k) plans. Unused benefitsor contributions for one qualified benefitmay only be used to reimburse expensesincurred during the grace period for that

same qualified benefit. The amount of un-used benefits and contributions availableduring the grace period may be limitedby the employer. A grace period mayextend to the fifteenth day of the thirdmonth after the end of the plan year (butmay be for a shorter period). Benefits orcontributions not used as of the end ofthe grace period are forfeited under theuse-or-lose rule. The grace period ap-plies to all employees who are participants(including through COBRA), as of thelast day of the plan year. Grace periodrules must apply uniformly to all partic-ipants. The grace period rules in theseproposed regulations are based on Notice2005–42, 2005–1 C.B. 1204, modifiedin Notice 2007–22, 2007–10 I.R.B. 670,see §601.601(d)(2)(ii)(b), amplified inNotice 2005–86, 2005–2 C.B. 1075, am-plified in Notice 2007–22, 2007–10 I.R.B.670, see §601.601(d)(2)(ii)(b). For eli-gibility to contribute to a Health SavingsAccount (HSA) during a grace period,see Notice 2005–86, 2005–2 C.B. 1075,see §601.601(d)(2)(ii)(b). For Form W–2reporting for unused dependent care assis-tance used for expenses incurred during agrace period, see Notice 2005–61, 2005–2C.B. 607, see §601.601(d)(2)(ii)(b).

Contributions to section 401(k) plansthrough a cafeteria plan

A cafeteria plan may include contri-butions to a section 401(k) plan. Section125(d)(2)(B). The new proposed regu-lations clarify the interactions betweensection 125 and section 401(k). Contribu-tions to a section 401(k) plan expressedas a percentage of compensation are per-mitted. Pursuant to §1.401(k)–1(a)(3)(ii),elective contributions to a section 401(k)plan may be made through automaticenrollment (that is, when the employeedoes not affirmatively elect cash, the em-ployee’s compensation is reduced by afixed percentage, which is contributed toa section 401(k) plan).

Nonqualified benefits

A cafeteria plan must not offer anyof the following benefits: scholarships(section 117); employer-provided mealsand lodging (section 119); educationalassistance (section 127); fringe benefits(section 132); long-term care insurance.

See section 125(f). Long-term care ser-vices are nonqualified benefits, H.R. Conf.Rep. No. 736, 104th Cong., 2d Sess. 296,reprinted in 1996 U.S.C.C.A.N. 2109. (AnHSA funded through a cafeteria plan may,however, be used to pay premiums forlong-term care insurance or for long-termcare services.) The new proposed regula-tions clarify that contributions to ArcherMedical Savings Accounts (sections 220,106(b)), group term life insurance for anemployee’s spouse, child or dependent,and elective deferrals to section 403(b)plans are also nonqualified benefits. Aplan offering any nonqualified benefit isnot a cafeteria plan. A cafeteria plan maynot offer a health FSA that provides forthe carryover of unused benefits. SeeNotice 2002–45, 2002–2 C.B. 93, Part I;Rev. Rul. 2002–41, 2002–2 C.B. 75, see§601.601(d)(2)(ii)(b).

After-tax employee contributions

The new proposed regulations allow acafeteria plan to offer after-tax employeecontributions for qualified benefits or paidtime off. A cafeteria plan may only offerthe taxable benefits specifically permittedin the new proposed regulations. Nonqual-ified benefits may not be offered through acafeteria plan, even if paid with after-taxemployee contributions.

Employer contributions through salaryreduction

Employees electing a qualified bene-fit through salary reduction are electing toforego salary and instead to receive a ben-efit which is excludible from gross incomebecause it is provided by employer contri-butions. Section 125 provides that the em-ployee is treated as receiving the qualifiedbenefit from the employer in lieu of thetaxable benefit. A cafeteria plan may alsoimpose reasonable fees to administer thecafeteria plan which may be paid throughsalary reduction. A cafeteria plan is not re-quired to allow employees to pay for anyqualified benefit with after-tax employeecontributions.

September 24, 2007 685 2007–39 I.R.B.

II. New Prop. §1.125–2—Elections incafeteria plans

Making, revoking and changing elections

Generally, a cafeteria plan must requireemployees to elect annually between tax-able benefits and qualified benefits. Elec-tions must be made before the earlier ofthe first day of the period of coverageor when benefits are first currently avail-able. The determination of whether a tax-able benefit is currently available does notdepend on whether it has been construc-tively received by the employee for pur-poses of section 451. Annual electionsgenerally must be irrevocable and may notbe changed during the plan year. However,§1.125–4 permits a cafeteria plan to pro-vide for changes in elections based on cer-tain changes in status. An employer thatwishes to permit such changes in electionsmust incorporate the rules in §1.125–4 inits written cafeteria plan. These proposedregulations omit the rule in Q & A–6(b)in Prop. §1.125–2 (1989) (cessation of re-quired contributions), because the changein status rules in §1.125–4 superseded thisprovision of the 1989 proposed regula-tions.

If HSA contributions are made throughsalary reduction under a cafeteria plan, em-ployees may prospectively elect, revoke orchange salary reduction elections for HSAcontributions at any time during the planyear with respect to salary that has not be-come currently available at the time of theelection.

A cafeteria plan is permitted to in-clude an automatic election for newemployees or current employees. Rev.Rul. 2002–27, 2002–1 C.B. 925, see§601.601(d)(2)(ii)(b). A new rule alsopermits a cafeteria plan to provide anoptional election for new employees be-tween cash and qualified benefits. Newemployees avoid gross income inclusionif they make an election within 30 daysafter the date of hire even if benefits pro-vided pursuant to the election relate backto the date of hire. However, salary re-duction amounts used to pay for such anelection must be from compensation notyet currently available on the date of theelection. Also, this special election rulefor new employees does not apply to anyemployee who terminates employmentand is rehired within 30 days after ter-

minating employment (or who returns toemployment following an unpaid leave ofabsence of less than 30 days).

New elections and revocations orchanges in elections can be made elec-tronically. The safe harbor for electronicelections in §1.401(a)–21 is available.Only an employee can make an electionor revoke or change his or her election.An employee’s spouse or dependent maynot make an election under a cafeteriaplan and may not revoke or change anemployee’s election.

III. New Prop. §1.125–5—Flexiblespending arrangements

Overview

In general, a flexible spending arrange-ment (FSA) is a benefit designed to re-imburse employees for expenses incurredfor certain qualified benefits, up to a max-imum amount not substantially in excessof the salary reduction and employer flex-credits allocated for the benefit. The max-imum amount of reimbursement reason-ably available must be less than five timesthe value of the coverage. Employer flex-credits are non-elective employer contri-butions that an employer makes availablefor every employee eligible to participatein the cafeteria plan, to be used at theemployee’s election only for one or morequalified benefits (but not as cash or othertaxable benefits). The three types of FSAsare dependent care assistance, adoption as-sistance and medical care reimbursements(health FSA).

Uniform coverage rule

The new proposed regulations retainthe rule that the maximum amount of re-imbursement from a health FSA must beavailable at all times during the periodof coverage (properly reduced as of anyparticular time for prior reimbursements).The uniform coverage rule does not applyto FSAs for dependent care assistance oradoption assistance.

Use-or-lose rule

An FSA must satisfy all the require-ments of section 125, including the prohi-bition against deferring compensation. Ingeneral, as discussed under “No deferral ofcompensation”, in order to satisfy this re-

quirement of section 125, all benefits andcontributions must be used by the end ofthe plan year (or grace period, if applica-ble), or are forfeited. The new proposedregulations continue the use-or-lose rule.

Period of coverage

The required period of coverage for allFSAs continues to be twelve months, withan exception for short plan years that sat-isfy the conditions in the new proposedregulations. The period of coverage andthe plan year need not be the same. Thebeginning and end of a period of cover-age is clarified. The new proposed regu-lations also clarify that FSAs for differentqualified benefits need not have the samecoverage period. See also “Grace period”,discussed in this preamble. The new pro-posed regulations also continue to providethat expenses are incurred when servicesare provided. Expenses incurred before orafter the period of coverage may not be re-imbursed.

Health FSA

A health FSA may only reimbursecertain substantiated section 213(d) med-ical care expenses incurred by the em-ployee, or by the employee’s spouseor dependents. A health FSA may belimited to a subset of permitted section213(d) medical expenses (for example,a health FSA is permitted to exclude re-imbursement of over-the-counter drugsdescribed in Rev. Rul. 2003–102, 2003–2C.B. 559, see §601.601(d)(2)(ii)(b)).Similarly, a health FSA may be anHSA-compatible limited-purpose healthFSA or post-deductible health FSA. Rev.Rul. 2004–45, 2004–1 C.B. 971, see§601.601(d)(2)(ii)(b), amplified, Notice2005–86, 2005–2 C.B. 1075. A healthFSA may not reimburse premiums for ac-cident and health insurance or long-termcare insurance. See section 125(f).

A health FSA must satisfy all require-ments of section 105(b), §§1.105–1 and1.105–2. The section 105(h) nondiscrim-ination rules apply to health FSAs. Allmedical expenses must be substantiatedbefore expenses are reimbursed. See In-curring and reimbursing expenses forqualified benefits, discussed in this pre-amble. The new proposed regulationsalso clarify when medical expenses are

2007–39 I.R.B. 686 September 24, 2007

incurred.1 A cafeteria plan may limitenrollment in a health FSA to those em-ployees who participate in the employer’saccident and health plan.

Qualified HSA distributions

Section 106(e), enacted in section302 of the Health Opportunity PatientEmpowerment Act of 2006, Public Law109–432 (120 Stat. 2922 (2006)) allows“qualified HSA distributions” from healthFSAs to HSAs. Section 106(e) appliesto distributions between December 20,2006 and December 31, 2011. The pro-posed regulations incorporate the rules onqualified HSA distributions set forth inNotice 2007–22, 2007–10 I.R.B. 670. See§601.601(d)(2)(ii)(b).

Dependent care assistance aftertermination

A new optional rule permits an em-ployer to reimburse a terminated em-ployee’s qualified dependent care ex-penses incurred after termination througha dependent care FSA, if all section 129requirements are otherwise satisfied.

Experience gains

If an employee fails to use all contri-butions and benefits for a plan year be-fore the end of the plan year (and the graceperiod, if applicable), those unused con-tributions and benefits are forfeited un-der the use-or-lose rule. Unused amountsare also known as experience gains. Thenew proposed regulations retain the for-feiture allocation rules in the 1989 pro-posed regulations, and clarify that the em-ployer sponsoring the cafeteria plan mayretain forfeitures, use forfeitures to defrayexpenses of administering the plan or al-locate forfeitures among employees con-tributing through salary reduction on a rea-sonable and uniform basis.

FSA Administrative rules

Salary reduction contributions may bemade at whatever interval the employer se-

lects, including ratably over the plan yearbased on the employer’s payroll periods orin equal installments at other regular inter-vals (for example, quarterly installments).These rules must apply uniformly to allparticipants.

IV. New Prop. §1.125–6—Substantiationof expenses for all cafeteria plans

Incurring and reimbursing expenses forqualified benefits

The new proposed regulations providethat only expenses for qualified benefitsincurred after the later of the effective dateor the adoption date of the cafeteria planare permitted to be reimbursed under thecafeteria plan. Similarly, if a plan amend-ment adds a new qualified benefit, only ex-penses incurred after the later of the effec-tive date or the adoption date are eligiblefor reimbursement.2 This rule applies toall qualified benefits. Similarly, a cafeteriaplan may pay or reimburse only expensesfor qualified benefits incurred during a par-ticipant’s period of coverage.

Substantiation and reimbursement ofexpenses for qualified benefits

The new proposed regulations provide,after an employee incurs an expense for aqualified benefit during the coverage pe-riod, the expense must first be substanti-ated before the expense may be paid or re-imbursed. All expenses must be substanti-ated (substantiating only a limited numberof total claims, or not substantiating claimsbelow a certain dollar amount does not sat-isfy the requirements in the new proposedregulations). See §1.105–2; Rev. Rul.2003–80; Rev. Rul. 2003–43, 2003–1C.B. 935, see §601.601(d)(2)(ii)(b); No-tice 2006–69, 2006–31 I.R.B. 107, Notice2007–2, 2007–2 I.R.B. 254. FSAs for de-pendent care assistance and adoption assis-tance must follow the substantiation proce-dures applicable to health FSAs.

Debit cards

The new proposed regulations incor-porate previously issued guidance onsubstantiating, paying and reimbursingexpenses for section 213(d) medical careincurred at a medical care provider whenpayment is made with a debit card. Rev.Rul. 2003–43, 2003–1 C.B. 935, am-plified, Notice 2006–69, 2006–31 I.R.B.107, Notice 2007–2, 2007–2 I.R.B. 254;Rev. Proc. 98–25, 1998–1 C.B. 689,see §601.601(d)(2)(ii)(b). Among thepermissible substantiation methods arecopayment matches, recurring expenses,and real-time substantiation. The new pro-posed regulations also allow point-of-salesubstantiation through matching inventoryinformation with a list of section 213(d)medical expenses. The employer is re-sponsible for ensuring that the inventoryinformation approval system complieswith the new regulations and with therecordkeeping requirements in section6001. Rev. Rul. 2003–43, 2003–1 C.B.935, amplified, Notice 2006–69, 2006–31I.R.B. 107, Notice 2007–2, 2007–2 I.R.B.254; Rev. Proc. 98–25, 1998–1 C.B. 689,see §601.601(d)(2)(ii)(b). The new pro-posed regulations also provide rules underwhich an FSA may pay or reimburse de-pendent care expenses using debit cards.

Pursuant to prior guidance (in Notice2006–69, 2006–31 I.R.B. 107, amplified,Notice 2007–2, 2007–2 I.R.B. 254), forplan years beginning after December 31,2006, the recordkeeping requirements de-scribed in paragraph (f) in §1.125–6 apply(that is, responsibility of employers rely-ing on the inventory information approvalsystem for health FSA debit cards to en-sure that the system complies with the newproposed recordkeeping requirements, in-cluding Rev. Proc. 98–25, 1998–1 C.B.689, Notice 2006–69, 2006–31 I.R.B. 107,amplified, Notice 2007–2, 2007–2 I.R.B.254. For health FSA debit card transac-tions occurring on or before December31, 2007, all supermarkets, grocery stores,discount stores and wholesale clubs that donot have a medical care merchant categorycode (as described in Rev. Rul. 2003–43,

1 See Rev. Rul. 2005–55, 2005–2 C.B. 284, and Rev. Rul. 2005–24, 2005–1 C.B. 892, see §601.601(d)(2)(ii)(b) (section 105(b) exclusion only applicable to reimbursements for medicalexpenses incurred by employee, or by the employee’s spouse or dependents); Rev. Rul. 2002–3, 2002–1 C.B. 316 (purported reimbursements to employees of health insurance premiums notpaid by employees and therefore impermissible); Rev. Rul. 2002–80, 2002–2 C.B. 925, see §601.601(d)(2)(ii)(b) (so-called advance reimbursements and purported loans are impermissible);Rev. Rul. 2003–43, 2003–1 C.B. 935, see §601.601(d)(2)(ii)(b); Notice 2006–69, 2006–31 I.R.B. 107 (substantiation requirements for debit cards), amplified in Notice 2007–2, 2007–2 I.R.B.254, see §601.601(d)(2)(ii)(b).

2 See American Family Mut. Ins. Co. v. United States, 815 F. Supp. 1206 (W.D. Wis. 1992); Wollenberg v. United States, 75 F. Supp.2d 1032 (D. Neb. 1999); Rev. Rul. 2002–58, 2002–2C.B. 541, see §601.601(d)(2)(ii)(b); Notice 97–9, section II (adoption assistance).

September 24, 2007 687 2007–39 I.R.B.

2003–1 C.B. 935, are nevertheless deemedto be an “other medical provider” as de-scribed in Rev. Rul. 2003–43. (For alist of merchant category codes, see Rev.Proc. 2004–43, 2004–2 C.B. 124.) Duringthis time period, mail-order vendors andweb-based vendors that sell prescriptiondrugs are also deemed to be an “othermedical provider” as described in Rev.Rul. 2003–43. After December 31, 2008,health FSA debit cards may not be usedat stores with the Drug Stores and Phar-macies merchant category code unless(1) the store participates in the inventoryinformation approval system described inNotice 2006–69, or (2) on a store loca-tion by store location basis, 90 percent ofthe store’s gross receipts during the priortaxable year consisted of items whichqualify as expenses for medical care undersection 213(d) (including nonprescrip-tion medications described in Rev. Rul.2003–102, 2003–2 C.B. 559). Notice2006–69, 2006–31 I.R.B. 107, amplified,Notice 2007–2, 2007–2 I.R.B. 254.

V. New Prop.§1.125–7—Nondiscriminationrules

Discriminatory benefits provided tohighly compensated participants and indi-viduals and key employees are includedin these employees’ gross income. Seesection 125(b), (c). The new proposedregulations reflect changes in tax law sinceProp. §1.125–1, Q & A–9 through 13 and19 were proposed in 1984, including thekey employee concentration test, statutorynontaxable benefits (enacted in the DeficitReduction Act of 1984 (DEFRA), PublicLaw 98–369, section 531(b), (98 Stat. 881(1984)), and the change in definition ofdependent in WFTRA.

The new proposed regulations provideadditional guidance on the cafeteria plannondiscrimination rules, including defini-tions of key terms, guidance on the eligi-bility test and the contributions and ben-efits tests, descriptions of employees al-lowed to be excluded from testing and asafe harbor nondiscrimination test for pre-mium-only-plans.

Specifically, the new proposed regula-tions define several key terms, includinghighly compensated individual or partic-ipant (consistent with the section 414(q)definition of highly compensated em-

ployee), officer, five percent shareholder,key employee and compensation. The newproposed regulations also provide guid-ance on the nondiscrimination as to eligi-bility requirement by incorporating someof the rules under section 410(b) (specif-ically the rules under §1.410(b)–4(b) and(c) dealing with reasonable classification,the safe harbor percentage test and theunsafe harbor percentage component ofthe facts and circumstances test).

The new proposed regulations also pro-vide additional guidance on the contribu-tions and benefits test and, unlike the priorproposed regulations, the new proposedregulations provide an objective test to de-termine when the actual election of bene-fits is discriminatory. Specifically, the newproposed regulations provide that a cafete-ria plan must give each similarly situatedparticipant a uniform opportunity to electqualified benefits, and that highly compen-sated participants must not actually dispro-portionately elect qualified benefits. Fi-nally, the new rules provide guidance onthe safe harbor for cafeteria plans provid-ing health benefits and create a safe harborfor premium-only-plans that satisfy certainrequirements.

The example in Prop. §1.125–1,Q & A–11 (1984) is deleted because itconcerns a qualified legal services plan,which is no longer a qualified benefit.

Other issues

These proposed regulations provideguidance under section 125 (26 U.S.C.125). Other statutes may impose addi-tional requirements (for example, the Em-ployee Retirement Income Security Actof 1974 (ERISA) (29 U.S.C. 1000), theHealth Insurance Portability and Account-ability Act of 1996 (HIPAA), (sections9801–9803); and the continuation cover-age requirements under the ConsolidatedOmnibus Budget Reconciliation Act of1985 (COBRA) (section 4980B).

Proposed Effective Date

With the exceptions noted in the “Effecton other documents” section of this pre-amble and under the “Debit cards” sectionof the preamble, it is proposed that theseregulations apply for plan years beginningon or after January 1, 2009. Taxpayersmay rely on these regulations for guidance

pending the issuance of final regulations.Prior published guidance on qualified ben-efits under sections 79, 105, 106, 129, 137and 223 that is affected by these proposedregulations remains applicable through theeffective date of the final regulations (ex-cept as modified in “Effect on other docu-ments” section of this preamble).

Effect on Other Documents

Notice 89–110, 1989–2 C.B. 447,see §601.601(d)(2)(ii)(b), states thatwhere group-term life insurance pro-vided to an employee by an employerexceeds $50,000, the employee includesin gross income the greater of the costof group-term life insurance shown in§1.79–3(d)(2), Table I (Table I ) on theexcess coverage or the employee’s salaryreduction and employer flex-credits forexcess coverage. Notice 89–110 is modi-fied, effective as of the date the proposedregulations are published in the FederalRegister.

Published guidance under §105(b)states that if any person has the rightto receive cash or any other taxable ornontaxable benefit under a health FSAother than the reimbursement of section213(d) medical expenses of the employee,employee’s spouse or employee’s depen-dents, then all distributions made fromthe arrangement are included in the em-ployee’s gross income, even amountspaid to reimburse medical care. See Rev.Rul. 2006–36, 2006–36 I.R.B. 353; Rev.Rul. 2005–24, 2005–1 C.B. 892; Rev.Rul. 2003–102, 2003–2 C.B. 559; No-tice 2002–45, 2002–2 C.B. 93; Rev. Rul.2002–41, 2002–2 C.B. 75; Rev. Rul.69–141, 1969–1 C.B. 48. New section106(e) provides that a health FSA willnot fail to satisfy the requirements of sec-tions 105 or 106 merely because the planprovides for a qualified HSA distribu-tion. Amounts rolled into an HSA maybe used for purposes other than reimburs-ing the section 213(d) medical expensesof the employee, spouse or dependents.Accordingly, Rev. Rul. 2006–36, Rev.Rul. 2005–24, Rev. Rul. 2003–102,Notice 2002–45, Rev. Rul. 2002–41,and Rev. Rul. 69–141 are modified withrespect to qualified HSA distributionsdescribed in section 106(e). See No-tice 2007–22, 2007–10 I.R.B. 670, see§601.601(d)(2)(ii)(b).

2007–39 I.R.B. 688 September 24, 2007

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significantregulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatory as-sessment is not required. It also has beendetermined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to this regulation. Itis hereby certified that the collection of in-formation in this regulation will not have asignificant economic impact on a substan-tial number of small entities. This certi-fication is based on the fact that the reg-ulations will only minimally increase theburdens on small entities. The require-ments under these regulations relating tomaintaining a section 125 cafeteria planare a minimal additional burden indepen-dent of the burdens encompassed under ex-isting rules for underlying employee ben-efit plans, which exist whether or not thebenefits are provided through a cafeteriaplan. In addition, most small entities thatwill maintain cafeteria plans already use athird-party plan administrator to adminis-ter the cafeteria plan. The collection ofinformation required in these regulations,which is required to comply with the exist-ing substantiation requirements of sections105, 106, 129 and 125, and the recordkeep-ing requirements of section 6001, will onlyminimally increase the third-party admin-istrator’s burden with respect to the cafete-ria plan. Therefore, an analysis under theRegulatory Flexibility Act (5 U.S.C. chap-ter 6) is not required. Pursuant to section7805(f) of the Internal Revenue Code, thisproposed regulation has been submitted tothe Chief Counsel for Advocacy of theSmall Business Administration for com-ment on its impact on small business.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written comments(a signed original and eight (8) copies)or electronic comments that are submittedtimely to the IRS. The IRS and TreasuryDepartment specifically request commentson the clarity of the proposed rules andhow they can be made easier to understand.In addition, comments are requested on thefollowing issues:

1. Whether, consistent with section125 of the Internal Revenue Code, mul-tiple employers (other than members ofa controlled group described in section125(g)(4)) may sponsor a single cafeteriaplan;

2. Whether salary reduction contribu-tions may be based on employees’ tips andhow that would work;

3. For cafeteria plans adopting thechange in status rules in §1.125–4, whena participant has a change in statusand changes his or her salary reductionamount, how should the participant’s uni-form coverage amount be computed afterthe change in status.

All comments will be available for pub-lic inspection and copying.

A public hearing has been scheduledfor November 15, 2007, beginning at 10a.m. in the Auditorium, Internal RevenueService, 1111 Constitution Avenue, NW,Washington, DC. Due to building securityprocedures, visitors must enter at the Con-stitution Avenue entrance. In addition, allvisitors must present photo identificationto enter the building. Because of accessrestrictions, visitors will not be admittedbeyond the immediate entrance area morethan 30 minutes before the hearing starts.For information about having your nameplaced on the building access list to attendthe hearing, see the “FOR FURTHER IN-FORMATION CONTACT” section of thispreamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit written or electronic comments andan outline of the topics to be discussedand the amount of time to be devoted toeach topic (a signed original and eight (8)copies) by October 25, 2007. A period of10 minutes will be allotted to each personfor making comments. An agenda show-ing the scheduling of the speakers will beprepared after the deadline for receivingoutlines has passed. Copies of the agendawill be available free of charge at the hear-ing.


The principal author of these proposedregulations is Mireille T. Khoury, Office ofDivision Counsel/Associate Chief Coun-sel (Tax Exempt and Government Enti-ties), Internal Revenue Service. However,

personnel from other offices of the IRS andTreasury Department participated in theirdevelopment.

* * * * *

Withdrawal of Proposed Regulations

Accordingly, under the authority of 26U.S.C. 7805, the notice of proposed rule-making (EE–16–79) that was published inthe Federal Register on Monday, May 7,1984 (49 FR 19321), and Monday, De-cember 31, 1984 (49 FR 50733), the no-tice of proposed rulemaking (EE–130–86)that was published in the Federal Regis-ter on Tuesday, March 7, 1989 (54 FR9460), and Friday, November 7, 1997 (62FR 60196) and the notice of proposed rule-making (REG–117162–99) that was pub-lished in the Federal Register on Thurs-day, March 23, 2000 (65 FR 15587) arewithdrawn.

Proposed Amendment to theRegulations

Accordingly, 26 CFR Part 1 is proposedto be amended as follows:

PART 1—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Par. 2. Sections 1.125–0, 1.125–1 and

1.125–2 are added to read as follows:

§1.125–0 Table of contents.

This section lists captions containedin §§1.125–1, 1.125–2, 1.125–5, 1.125–6and §1.125–7.

§1.125–1 Cafeteria plans; general rules.

(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.

September 24, 2007 689 2007–39 I.R.B.

(m) Payment or reimbursement of em-ployees’ individual accident and health in-surance premiums.

(n) Section 105 rules for accident andhealth plan offered through a cafeteriaplan.

(o) Prohibition against deferred com-pensation.

(p) Benefits relating to more than oneyear.

(q) Nonqualified benefits.(r) Employer contributions to a cafete-

ria plan.(s) Effective/applicability date.

§1.125–2 Cafeteria plans; elections.

(a) Rules relating to making electionsand revoking elections.

(b) Automatic elections.(c) Election rules for salary reduction

contributions to HSAs.(d) Optional election for new employ-

ees.(e) Effective/applicability date.

§1.125–5 Flexible spendingarrangements.

(a) Definition of flexible spending ar-rangement.

(b) Flex-credits allowed.(c) Use-or-lose rule.(d) Uniform coverage rules applicable

to health FSAs.(e) Required period of coverage for a

health FSA, dependent care FSA and adop-tion assistance FSA.

(f) Coverage on a month-by-month orexpense-by-expense basis prohibited.

(g) FSA administrative practices.(h) Qualified benefits permitted to be

offered through a FSA.(i) Section 129 rules for dependent care

assistance program offered through a cafe-teria plan.

(j) Section 137 rules for adoption assis-tance program offered through a cafeteriaplan.

(k) FSAs and the rules governing thetax-favored treatment of employer-pro-vided health benefits.

(l) Section 105(h) requirements.(m) HSA-compatible FSAs- lim-

ited-purpose health FSAs and post-de-ductible health FSAs.

(n) Qualified HSA distributions.(o) FSA experience gains or forfeitures.(p) Effective/applicability date.

§1.125–6 Substantiation of expenses forall cafeteria plans.

(a) Cafeteria plan payments and reim-bursements.

(b) Rules for claims substantiation forcafeteria plans.

(c) Debit cards — overview.(d) Mandatory rules for all debit cards

usable to pay or reimburse medical ex-penses.

(e) Substantiation of expenses incurredat medical care providers and certain otherstores with Drug Stores and Pharmaciesmerchant category code.

(f) Inventory information approval sys-tem.

(g) Debit cards used to pay or reimbursedependent care assistance.

(h) Effective/applicability date.

§1.125–7 Cafeteria plannondiscrimination rules.

(a) Definitions.(b) Nondiscrimination as to eligibility.(c) Nondiscrimination as to contribu-

tions and benefits.(d) Key employees.(e) Section 125(g)(2) safe harbor for

cafeteria plans providing health benefits.(f) Safe harbor test for premium-only-

plans.(g) Permissive disaggregation for

nondiscrimination testing.(h) Optional aggregation of plans for

nondiscrimination testing.(i) Employees of certain controlled

groups.(j) Time to perform nondiscrimination

testing.(k) Discrimination in actual operation

prohibited.(l) Anti-abuse rule.(m) Tax treatment of benefits in a cafe-

teria plan.(n) Employer contributions to employ-

ees’ Health Savings Accounts.(o) Effective/applicability date.

§1.125–1 Cafeteria plans; general rules.

(a) Definitions. The definitions set forthin this paragraph (a) apply for purposes ofsection 125 and the regulations.

(1) The term cafeteria plan means aseparate written plan that complies withthe requirements of section 125 and the

regulations, that is maintained by an em-ployer for the benefit of its employees andthat is operated in compliance with the re-quirements of section 125 and the regula-tions. All participants in a cafeteria planmust be employees. A cafeteria plan mustoffer at least one permitted taxable benefit(as defined in paragraph (a)(2) of this sec-tion) and at least one qualified benefit (asdefined in paragraph (a)(3) of this section).A cafeteria plan must not provide for defer-ral of compensation (except as specificallypermitted in paragraph (o) of this section).

(2) The term permitted taxable benefitmeans cash and certain other taxable ben-efits treated as cash for purposes of sec-tion 125. For purposes of section 125,cash means cash compensation (includ-ing salary reduction), payments for annualleave, sick leave, or other paid time offand severance pay. A distribution from atrust described in section 401(a) is not cashfor purposes of section 125. Other tax-able benefits treated as cash for purposesof section 125 are:

(i) Property;(ii) Benefits attributable to employer

contributions that are currently taxableto the employee upon receipt by the em-ployee; and

(iii) Benefits purchased with after-taxemployee contributions, as described inparagraph (h) of this section.

(3) Qualified benefit. Except as other-wise provided in section 125(f) and para-graph (q) of this section, the term quali-fied benefit means any benefit attributableto employer contributions to the extent thatsuch benefit is not currently taxable to theemployee by reason of an express provi-sion of the Internal Revenue Code (Code)and which does not defer compensation(except as provided in paragraph (o) of thissection). The following benefits are qual-ified benefits that may be offered under acafeteria plan and are excludible from em-ployees’ gross income when provided inaccordance with the applicable provisionsof the Code—

(A) Group-term life insurance on thelife of an employee in an amount that isless than or equal to the $50,000 excludiblefrom gross income under section 79(a), butnot combined with any permanent benefitwithin the meaning of §1.79–0;

(B) An accident and health plan ex-cludible from gross income under section105 or 106, including self-insured medical

2007–39 I.R.B. 690 September 24, 2007

reimbursement plans (such as health FSAsdescribed in §1.125–5);

(C) Premiums for COBRA continuationcoverage (if excludible under section 106)under the accident and health plan of theemployer sponsoring the cafeteria plan orpremiums for COBRA continuation cover-age of an employee of the employer spon-soring the cafeteria plan under an accidentand health plan sponsored by a differentemployer;

(D) An accidental death and dismem-berment insurance policy (section 106);

(E) Long-term or short-term disabilitycoverage (section 106);

(F) Dependent care assistance program(section 129);

(G) Adoption assistance (section 137);(H) A qualified cash or deferred ar-

rangement that is part of a profit-sharingplan or stock bonus plan, as described inparagraph (o)(3) of this section (section401(k));

(I) Certain plans maintained by educa-tional organizations (section 125(d)(2)(C)and paragraph (o)(3)(iii) of this section);and

(J) Contributions to Health SavingsAccounts (HSAs) (sections 223 and125(d)(2)(D)).

(4) Dependent. The term dependentgenerally means a dependent as defined insection 152. However, the definition of de-pendent is modified to conform with theunderlying Code section for the qualifiedbenefit. For example, for purposes of abenefit under section 105, the term depen-dent means a dependent as defined in sec-tion 152, determined without regard to sec-tion 152(b)(1), (b)(2) or (d)(1)(B).

(5) Premium-only-plan. A pre-mium-only-plan is a cafeteria plan thatoffers as its sole benefit an election be-tween cash (for example, salary) andpayment of the employee share of theemployer-provided accident and healthinsurance premium (excludible from theemployee’s gross income under section106).

(b) General rules—(1) Cafeteria plans.Section 125 is the exclusive means bywhich an employer can offer employeesan election between taxable and nontax-able benefits without the election itselfresulting in inclusion in gross income bythe employees. Section 125 provides thatcash (including certain taxable benefits)offered to an employee through a nondis-

criminatory cafeteria plan is not includiblein the employee’s gross income merelybecause the employee has the opportu-nity to choose among cash and qualifiedbenefits (within the meaning of section125(e)) through the cafeteria plan. Sec-tion 125(a), (d)(1). However, if a planoffering an employee an election betweentaxable benefits (including cash) and non-taxable qualified benefits does not meetthe section 125 requirements, the electionbetween taxable and nontaxable benefitsresults in gross income to the employee,regardless of what benefit is elected andwhen the election is made. An employeewho has an election among nontaxablebenefits and taxable benefits (includingcash) that is not through a cafeteria planthat satisfies section 125 must includein gross income the value of the taxablebenefit with the greatest value that the em-ployee could have elected to receive, evenif the employee elects to receive only thenontaxable benefits offered. The amountof the taxable benefit is includible in theemployee’s income in the year in whichthe employee would have actually re-ceived the taxable benefit if the employeehad elected such benefit. This is the resulteven if the employee’s election betweenthe nontaxable benefits and taxable bene-fits is made prior to the year in which theemployee would actually have receivedthe taxable benefits. See paragraph (q) in§1.125–1 for nonqualified benefits.

(2) Nondiscrimination rules for qual-ified benefits. Accident and health plancoverage, group-term life insurance cov-erage, and benefits under a dependentcare assistance program or adoption assis-tance program do not fail to be qualifiedbenefits under a cafeteria plan merely be-cause they are includible in gross incomebecause of applicable nondiscrimina-tion requirements (for example, sections79(d), 105(h),129(d), 137(c)(2)). See also§§1.105–11(k) and 1.125–7.

(3) Examples. The following examplesillustrate the rules of paragraph (b)(1) ofthis section.

Example 1. Distributions from qualified pensionplan used for health insurance premiums. (i) Em-ployer A maintains a qualified section 401(a) retire-ment plan for employees. Employer A also providesaccident and health insurance (as described in sec-tion 106) for employees and former employees, theirspouses and dependents. The health insurance premi-ums are partially paid through a cafeteria plan. Noneof Employer A’s employees are public safety officers.

Employer A’s health plan allows former employeesto elect to have distributions from the qualified re-tirement plan applied to pay for the health insurancepremiums through the cafeteria plan.

(ii) Amounts distributed from the qualified retire-ment plan which the former employees elect to haveapplied to pay health insurance premiums through thecafeteria plan are includible in their gross income.The same result occurs if distributions from the quali-fied retirement plan are applied directly to reimbursesection 213(d) medical care expenses incurred by aformer employee or his or her spouse or dependents.These distributions are includible in their income, andare not cash for purposes of section 125. The plan isnot a cafeteria plan with respect to former employees.

Example 2. Severance pay used to pay COBRApremiums. Employer B maintains a cafeteria plan,which offers employees an election between cashand employer-provided accident and health insur-ance (excludible from employees’ gross incomeunder section 106). Employer B pays terminatingemployees severance pay. The cafeteria plan alsoallows a terminating employee to elect between re-ceiving severance pay and using the severance payto pay the COBRA premiums for the accident andhealth insurance. These provisions in the cafeteriaplan are consistent with the requirements in section125.

(4) Election by participants. (i) In gen-eral. A cafeteria plan must offer partici-pants the opportunity to elect between atleast one permitted taxable benefit and atleast one qualified benefit. For example,if employees are given the opportunity toelect only among two or more nontaxablebenefits, the plan is not a cafeteria plan.Similarly, a plan that only offers the elec-tion among salary, permitted taxable bene-fits, paid time off or other taxable benefitsis not a cafeteria plan. See section 125(a),(d). See §1.125–2 for rules on elections.

(ii) Premium-only-plan. A cafeteriaplan may be a premium-only-plan.

(iii) Examples. The following examplesillustrate the rules of paragraph (b)(4)(i) ofthis section.

Example 1. No election. Employer C covers allits employees under its accident and health plan (ex-cludible from employees’ gross income under sec-tion 106). Coverage is mandatory (that is, employeeshave no election between cash and the Employer C’saccident and health plan). This plan is not a cafeteriaplan, because the plan offers employees no electionbetween taxable and nontaxable benefits. The acci-dent and health coverage is excludible from employ-ees’ gross income.

Example 2. Election between cash and at leastone qualified benefit. Employer D offers its employ-ees a plan with an election between cash and an em-ployer-provided accident and health plan (excludiblefrom employees’ gross income under section 106). Ifthe plan also satisfies all the other requirements ofsection 125, the plan is a cafeteria plan because it of-fers an election between at least one taxable benefitand at least one nontaxable qualified benefit.

September 24, 2007 691 2007–39 I.R.B.

Example 3. Election between employer flex-cred-its and qualified benefits. Employer E offers its em-ployees an election between an employer flex-credit(as defined in paragraph (b) in §1.125–5) and quali-fied benefits. If an employee does not elect to applythe entire employer flex-credit to qualified benefits,the employee will receive no cash or other taxablebenefit for the unused employer flex-credit. The planis not a cafeteria plan because it does not offer an elec-tion between at least one taxable benefit and at leastone nontaxable qualified benefit.

Example 4. No election between cash andqualified benefits for certain employees. (i) Em-ployer F maintains a calendar year plan offeringemployer-provided accident and health insurancecoverage which includes employee-only and familycoverage options.

(ii) The plan provides for an automatic enrollmentprocess when a new employee is hired, or during theannual election period under the plan: only employ-ees who certify that they have other health coverageare permitted to elect to receive cash. Employees whocannot certify are covered by the accident and healthinsurance on a mandatory basis. Employer F doesnot otherwise request or collect information from em-ployees regarding other health coverage as part of theenrollment process. If the employee has a spouse orchild, the employee can elect between cash and fam-ily coverage.

(iii) When an employee is hired, the employee re-ceives a notice explaining the plan’s automatic enroll-ment process. The notice includes the salary reduc-tion amounts for employee-only coverage and familycoverage, procedures for certifying whether the em-ployee has other health coverage, elections for familycoverage, information on the time by which a certi-fication or election must be made, and the period forwhich a certification or election will be effective. Thenotice is also given to each current employee beforethe beginning of each plan year, (except that the no-tice for a current employee includes a description ofthe employee’s existing coverage, if any).

(iv) For a new employee, an election to receivecash or to have family coverage is effective if madewhen the employee is hired. For a current employee,an election is effective if made prior to the start ofeach calendar year or under any other circumstancespermitted under §1.125–4. An election for any prioryear carries over to the next succeeding plan yearunless changed. Certification that the employee hasother health coverage must be made annually.

(v) Contributions used to purchase employer-pro-vided accident and health coverage under section 125are not includible in an employee’s gross income ifthe employee can elect cash. Section 125 does notapply to the employee-only coverage of an employeewho cannot certify that he or she has other health cov-erage and, therefore, does not have the ability to electcash in lieu of health coverage.

(5) No deferred compensation. Exceptas provided in paragraph (o) of this section,in order for a plan to be a cafeteria plan, thequalified benefits and the permitted tax-able benefits offered through the cafeteriaplan must not defer compensation. For ex-ample, a cafeteria plan may not provide forretirement health benefits for current em-

ployees beyond the current plan year orgroup-term life insurance with a perma-nent benefit, as defined under §1.79–0.

(c) Written plan requirements—(1)General rule. A cafeteria plan must con-tain in writing the information describedin this paragraph (c), and depending onthe qualified benefits offered in the plan,may also be required to contain additionalinformation described in paragraphs (c)(2)and (c)(3) of this section. The cafeteriaplan must be adopted and effective on orbefore the first day of the cafeteria planyear to which it relates. The terms of theplan must apply uniformly to all partici-pants. The cafeteria plan document maybe comprised of multiple documents. Thewritten cafeteria plan must contain all ofthe following information—

(i) A specific description of each of thebenefits available through the plan, includ-ing the periods during which the benefitsare provided (the periods of coverage);

(ii) The plan’s rules governing partic-ipation, and specifically requiring that allparticipants in the plan be employees;

(iii) The procedures governing employ-ees’ elections under the plan, including theperiod when elections may be made, theperiods with respect to which elections areeffective, and providing that elections areirrevocable, except to the extent that theoptional change in status rules in §1.125–4are included in the cafeteria plan;

(iv) The manner in which employercontributions may be made under the plan,(for example, through an employee’ssalary reduction election or by non-elective employer contributions (that is,flex-credits, as defined in paragraph (b) in§1.125–5) or both);

(v) The maximum amount of employercontributions available to any employeethrough the plan, by stating:

(A) The maximum amount of electivecontributions (i.e., salary reduction) avail-able to any employee through the plan, ex-pressed as a maximum dollar amount or amaximum percentage of compensation orthe method for determining the maximumdollar amount; and

(B) For contributions to section 401(k)plans, the maximum amount of electivecontributions available to any employeethrough the plan, expressed as a maximumdollar amount or maximum percentage ofcompensation that may be contributed as

elective contributions through the plan byemployees.

(vi) The plan year of the cafeteria plan;(vii) If the plan offers paid time off, the

required ordering rule for use of nonelec-tive and elective paid time off in paragraph(o)(4) of this section;

(viii) If the plan includes flexiblespending arrangements (as defined in§1.125–5(a)), the plan’s provisions com-plying with any additional requirementsfor those FSAs (for example, the uniformcoverage rule and the use-or-lose rules inparagraphs (d) and (c) in §1.125–5);

(ix) If the plan includes a grace period,the plan’s provisions complying with para-graph (e) of this section; and

(x) If the plan includes distributionsfrom a health FSA to employees’ HSAs,the plan’s provisions complying with para-graph (n) in §1.125–5.

(2) Additional requirements under sec-tions 105(h), 129, and 137. A written planis required for self-insured medical re-imbursement plans (§1.105–11(b)(1)(i)),dependent care assistance programs (sec-tion 129(d)(1)), and adoption assistance(section 137(c)). Any of these plans orprograms offered through a cafeteria planthat satisfies the written plan require-ment in this paragraph (c) for the benefitsunder these plans and programs also sat-isfies the written plan requirements in§1.105–11(b)(1)(i), section 129(d)(1), andsection 137(c) (whichever is applicable).Alternatively, a self-insured medical re-imbursement plan, a dependent care assis-tance program, or an adoption assistanceprogram is permitted to satisfy the re-quirements in §1.105–11(b)(1)(i), section129(d)(1), or section 137(c) (whicheveris applicable) through a separate writtenplan, and not as part of the written cafete-ria plan.

(3) Additional requirements under sec-tion 401(k). See §1.401(k)–1(e)(7) for ad-ditional requirements that must be satisfiedin the written plan if the plan offers defer-rals into a section 401(k) plan.

(4) Cross-reference allowed. In de-scribing the benefits available through thecafeteria plan, the written cafeteria planneed not be self-contained. For example,the written cafeteria plan may incorpo-rate by reference benefits offered throughother separate written plans, such as asection 401(k) plan, or coverage under adependent care assistance program (sec-

2007–39 I.R.B. 692 September 24, 2007

tion 129), without describing in full thebenefits established through these otherplans. But, for example, if the cafeteriaplan offers different maximum levels ofcoverage for dependent care assistanceprograms, the descriptions in the separatewritten plan must specify the availablemaximums.

(5) Amendments to cafeteria plan. Anyamendment to the cafeteria plan must bein writing. A cafeteria plan is permittedto be amended at any time during a planyear. However, the amendment is onlypermitted to be effective for periods afterthe later of the adoption date or effectivedate of the amendment. For an amend-ment adding a new benefit, the cafeteriaplan must pay or reimburse only those ex-penses for new benefits incurred after thelater of the amendment’s adoption date oreffective date.

(6) Failure to satisfy written plan re-quirements. If there is no written cafete-ria plan, or if the written plan fails to sat-isfy any of the requirements in this para-graph (c) (including cross-referenced re-quirements), the plan is not a cafeteriaplan and an employee’s election betweentaxable and nontaxable benefits results ingross income to the employee.

(7) Operational failure—(i) In general.If the cafeteria plan fails to operate accord-ing to its written plan or otherwise failsto operate in compliance with section 125and the regulations, the plan is not a cafete-ria plan and employees’ elections betweentaxable and nontaxable benefits result ingross income to the employees.

(ii) Failure to operate according to writ-ten cafeteria plan or section 125. Exam-ples of failures resulting in section 125 notapplying to a plan include the following—

(A) Paying or reimbursing expenses forqualified benefits incurred before the laterof the adoption date or effective date of thecafeteria plan, before the beginning of aperiod of coverage or before the later of thedate of adoption or effective date of a planamendment adding a new benefit;

(B) Offering benefits other than permit-ted taxable benefits and qualified benefits;

(C) Operating to defer compensation(except as permitted in paragraph (o) ofthis section);

(D) Failing to comply with the uni-form 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 elec-tions or make new elections, except as pro-vided in §1.125–4 and paragraph (a) in§1.125–2;

(G) Failing to comply with the substan-tiation requirements of §1.125–6;

(H) Paying or reimbursing expenses inan FSA other than expenses expressly per-mitted in paragraph (h) in §1.125–5;

(I) Allocating experience gains otherthan as expressly permitted in paragraph(o) in §1.125–5;

(J) Failing to comply with the grace pe-riod rules in paragraph (e) of this section;or

(K) Failing to comply with the qualifiedHSA distribution rules in paragraph (n) in§1.125–5.

(d) Plan year requirements—(1) Twelveconsecutive months. The plan year mustbe specified in the cafeteria plan. The planyear of a cafeteria plan must be twelve con-secutive months, unless a short plan year isallowed under this paragraph (d). A planyear is permitted to begin on any day ofany calendar month and must end on thepreceding day in the immediately follow-ing year (for example, a plan year that be-gins on October 15, 2007, must end on Oc-tober 14, 2008). A calendar year plan yearis a period of twelve consecutive monthsbeginning on January 1 and ending on De-cember 31 of the same calendar year. Aplan year specified in the cafeteria plan iseffective for the first plan year of a cafete-ria plan and for all subsequent plan years,unless changed as provided in paragraph(d)(2) of this section.

(2) Changing plan year. The plan yearis permitted to be changed only for a validbusiness purpose. A change in the planyear is not permitted if a principal pur-pose of the change in plan year is to cir-cumvent the rules of section 125 or theseregulations. If a change in plan year doesnot satisfy this subparagraph, the attemptto change the plan year is ineffective andthe plan year of the cafeteria plan remainsthe same.

(3) Short plan year. A short plan yearof less than twelve consecutive months ispermitted for a valid business purpose.

(4) Examples. The following examplesillustrate the rules in paragraph (d) of thissection:

Example 1. Employer with calendar year. Em-ployer G, with a calendar taxable year, first estab-lishes a cafeteria plan effective July 1, 2009. Thecafeteria plan specifies a calendar plan year. The firstcafeteria plan year is the period beginning on July 1,2009, and ending on December 31, 2009. EmployerG has a business purpose for a short first cafeteriaplan year.

Example 2. Employer changes insurance carrier.Employer H establishes a cafeteria plan effectiveJanuary 1, 2009, with a calendar year plan year.The cafeteria plan offers an accident and health planthrough Insurer X. In March 2010, Employer Hcontracts to provide accident and health insurancethrough another insurance company, Y. Y’s accidentand health insurance is offered on a July 1-June 30benefit year. Effective July 1, 2010, Employer Hamends the plan to change to a July 1-June 30 planyear. Employer H has a business purpose for chang-ing the cafeteria plan year and for the short plan yearending June 30, 2010.

(5) Significance of plan year. The planyear generally is the coverage period forbenefits provided through the cafeteriaplan to which annual elections for thesebenefits apply. Benefits elected pursuantto the employee’s election for a plan yeargenerally may not be carried forward tosubsequent plan years. However, see thegrace period rule in paragraph (e) of thissection.

(e) Grace period—(1) In general. Acafeteria plan may, at the employer’s op-tion, include a grace period of up to the fif-teenth day of the third month immediatelyfollowing the end of each plan year. If acafeteria plan provides for a grace period,an employee who has unused benefits orcontributions relating to a qualified benefit(for example, health flexible spending ar-rangement (health FSA) or dependent careassistance) from the immediately preced-ing plan year, and who incurs expensesfor that same qualified benefit during thegrace period, may be paid or reimbursedfor those expenses from the unused bene-fits or contributions as if the expenses hadbeen incurred in the immediately preced-ing plan year. A grace period is availablefor all qualified benefits described in para-graph (a)(3) of this section, except that thegrace period does not apply to paid timeoff and elective contributions under a sec-tion 401(k) plan. The effect of the graceperiod is that the employee may have aslong as 14 months and 15 days (that is, the12 months in the current cafeteria plan yearplus the grace period) to use the benefits orcontributions for a plan year before thoseamounts are forfeited under the use-or-loserule in paragraph (c) in §1.125–5. If the

September 24, 2007 693 2007–39 I.R.B.

grace period is added to a cafeteria planthrough an amendment, all requirements inparagraph (c) of this section must be satis-fied.

(2) Grace period optional features. Agrace period provision may contain any orall of the following—

(i) The grace period may apply to somequalified benefits described in paragraph(a)(3) of this section, but not to others;

(ii) The grace period provision maylimit the amount of unused benefits orcontributions available during the graceperiod. The limit must be uniform andapply to all participants. However, thelimit must not be based on a percentageof the amount of the unused benefits orcontributions remaining at the end of theimmediately prior plan year;

(iii) The last day of the grace periodmay be sooner than the fifteenth day ofthe third month immediately following theend of the plan year (that is, the grace pe-riod may be shorter than two and one halfmonths);

(iv) The grace period provision is per-mitted to treat expenses for qualified ben-efits incurred during the grace period ei-ther as expenses incurred during the im-mediately preceding plan year or as ex-penses incurred during the current planyear (for example, the plan may first applythe unused contributions or benefits fromthe immediately preceding year to pay orreimburse grace period expenses and then,when the unused contributions and bene-fits from the prior year are exhausted, thegrace period expenses may be paid fromcurrent year contributions and benefits.);and

(v) The grace period provision may per-mit the employer to defer the allocation ofexpenses described in paragraph (e)(2)(iv)of this section until after the end of thegrace period.

(3) Grace period requirements. A graceperiod must satisfy the requirements inparagraph (c) of this section and all of thefollowing requirements:

(i) The grace period provisions in thecafeteria plan (including optional provi-sions in paragraph (e)(2) of this section)must apply uniformly to all participantsin the cafeteria plan, determined as of thelast day of the plan year. Participants inthe cafeteria plan through COBRA andparticipants who were participants as ofthe last day of the plan year but termi-

nate during the grace period are partici-pants for purposes of the grace period. See§54.4980B–2, Q & A–8 of this chapter;

(ii) The grace period provision in thecafeteria plan must state that unused ben-efits or contributions relating to a particu-lar qualified benefit may only be used topay or reimburse expenses incurred withrespect to the same qualified benefit. Forexample, unused amounts elected to payor reimburse medical expenses in a healthFSA may not be used to pay or reimbursedependent care expenses incurred duringthe grace period; and

(iii) The grace period provision in thecafeteria plan must state that to the extentany unused benefits or contributions fromthe immediately preceding plan year ex-ceed the expenses for the qualified benefitincurred during the grace period, those re-maining unused benefits or contributionsmay not be carried forward to any sub-sequent period (including any subsequentplan year), cannot be cashed-out and mustbe forfeited under the use-or-lose rule. Seeparagraph (c) in §1.125–5.

(4) Examples. The following examplesillustrate the rules in this paragraph (e).

Example 1. Expenses incurred during graceperiod and immediately following plan year. (i)Employer I’s calendar year cafeteria plan includes agrace period allowing all participants to apply unusedbenefits or contributions remaining at the end of theplan year to qualified benefits incurred during thegrace period immediately following that plan year.The grace period for the plan year ending December31, 2009, ends on March 15, 2010.

(ii) Employee X timely elected salary reductionof $1,000 for a health FSA for the plan year endingDecember 31, 2009. As of December 31, 2009, X has$200 remaining unused in his health FSA. X timelyelected salary reduction for a health FSA of $1,500for the plan year ending December 31, 2010.

(iii) During the grace period from January 1through March 15, 2010, X incurs $300 of unre-imbursed medical expenses (as defined in section213(d)). The unused $200 from the plan year endingDecember 31, 2009, is applied to pay or reimburse$200 of X’s $300 of medical expenses incurredduring the grace period. Therefore, as of March16, 2010, X has no unused benefits or contributionsremaining for the plan year ending December 31,2009.

(iv) The remaining $100 of medical expenses in-curred between January 1 and March 15, 2010, is paidor reimbursed from X’s health FSA for the plan yearending December 31, 2010. As of March 16, 2010, Xhas $1,400 remaining in the health FSA for the planyear ending December 31, 2010.

Example 2. Unused benefits exceed expenses in-curred during grace period. Same facts as Example1, except that X incurs $150 of section 213(d) medicalexpenses during the grace period (January 1 throughMarch 15, 2010). As of March 16, 2010, X has $50

of unused benefits or contributions remaining for theplan year ending December 31, 2009. The unused$50 cannot be cashed-out, converted to any other tax-able or nontaxable benefit, or used in any other planyear (including the plan year ending December 31,2009). The unused $50 is subject to the use-or-loserule in paragraph (c) in §1.125–5 and is forfeited. Asof March 16, 2010, X has the entire $1,500 electedin the health FSA for the plan year ending December31, 2010.

Example 3. Terminated participants. (i) Em-ployer J’s cafeteria plan includes a grace period al-lowing all participants to apply unused benefits orcontributions remaining at the end of the plan yearto qualified benefits incurred during the grace periodimmediately following that plan year. For the planyear ending on December 31, 2009, the grace periodends March 15, 2010.

(ii) Employees A, B, C, and D each timely elected$1,200 salary reduction for a health FSA for the planyear ending December 31, 2009. Employees A andB terminated employment on September 15, 2009.Each has $500 of unused benefits or contributions inthe health FSA.

(iii) Employee A elected COBRA for the healthFSA. Employee A is a participant in the cafeteria planas of December 31, 2009, the last day of the 2009plan year. Employee A has $500 of unused benefitsor contributions available during the grace period forthe 2009 plan year (ending March 15, 2010).

(iv) Employee B did not elect COBRA for thehealth FSA. Employee B is not a participant in thecafeteria plan as of December 31, 2009. The graceperiod does not apply to Employee B.

(v) Employee C has $500 of unused benefits inhis health FSA as of December 31, 2009, and termi-nated employment on January 15, 2010. Employee Cis a participant in the cafeteria plan as of December31, 2009 and has $500 of unused benefits or contribu-tions available during the grace period ending March15, 2010, even though he terminated employment onJanuary 15, 2010.

(vi) Employee D continues to work for EmployerH throughout 2009 and 2010, also has $500 of unusedbenefits or contributions in his health FSA as of De-cember 31, 2009, but made no health FSA electionfor 2010. Employee D is a participant in the cafe-teria plan as of December 31, 2009 and has $500 ofunused benefits or contributions available during thegrace period ending March 15, 2010, even though heis not a participant in a health FSA for the 2010 planyear.

(f) Run-out period. A cafeteria plan ispermitted to contain a run-out period asdesignated by the employer. A run-out pe-riod is a period after the end of the planyear (or grace period) during which a par-ticipant can submit a claim for reimburse-ment for a qualified benefit incurred dur-ing the plan year (or grace period). Thus, aplan is also permitted to provide a deadlineon or after the end of the plan year (or graceperiod) for submitting a claim for reim-bursement for the plan year. Any run-outperiod must be provided on a uniform and

2007–39 I.R.B. 694 September 24, 2007

consistent basis with respect to all partici-pants.

(g) Employee for purposes of section125—(1) Current employees, former em-ployees. The term employee includes anycurrent or former employee (including anylaid-off employee or retired employee) ofthe employer. See paragraph (g)(3) of thissection concerning limits on participationby former employees. Specifically, theterm employee includes the following—

(i) Common law employee;(ii) Leased employee described in sec-

tion 414(n);(iii) Full-time life insurance salesman

(as defined in section 7701(a)(20)); and(iv) A current employee or former em-

ployee described in paragraphs (g)(1)(i)through (iii) of this section.

(2) Self-employed individual not an em-ployee. (i) In general. The term employeedoes not include a self-employed individ-ual or a 2-percent shareholder of an S cor-poration, as defined in paragraph (g)(2)(ii)of this subsection. For example, a soleproprietor, a partner in a partnership, or adirector solely serving on a corporation’sboard of directors (and not otherwise pro-viding services to the corporation as anemployee) is not an employee for purposesof section 125, and thus is not permitted toparticipate in a cafeteria plan. However,a sole proprietor may sponsor a cafete-ria plan covering the sole proprietor’s em-ployees (but not the sole proprietor). Sim-ilarly, a partnership or S corporation maysponsor a cafeteria plan covering employ-ees (but not a partner or 2-percent share-holder of an S corporation).

(ii) Two percent shareholder of anS corporation. A 2-percent shareholder ofan S corporation has the meaning set forthin section 1372(b).

(iii) Certain dual status individuals. Ifan individual is an employee of an em-ployer and also provides services to thatemployer as an independent contractor ordirector (for example, an individual is botha director and an employee of a C corp),the individual is eligible to participate inthat employer’s cafeteria plan solely in hisor her capacity as an employee. This ruledoes not apply to partners or to 2-percentshareholders of an S corporation.

(iv) Examples. The following examplesillustrate the rules in paragraphs (g)(2)(ii)and (g)(2)(iii) of this section:

Example 1. Two-percent shareholders of anS corporation. (i) Employer K, an S corporation,maintains a cafeteria plan for its employees (otherthan 2-percent shareholders of an S corporation).Employer K’s taxable year and the plan year arethe calendar year. On January 1, 2009, individual Zowns 5 percent of the outstanding stock in EmployerK. Y, who owns no stock in Employer K, is marriedto Z. Y and Z are employees of Employer K. Z is a2-percent shareholder in Employer K (as defined insection 1372(b)). Y is also a 2-percent shareholderin Employer K by operation of the attribution rulesin section 318(a)(1)(A)(i).

(ii) On July 15, 2009, Z sells all his stock in Em-ployer K to an unrelated third party, and ceases to bea 2-percent shareholder. Y and Z continue to workas employees of Employer K during the entire 2009calendar year. Y and Z are ineligible to participate inEmployer K’s cafeteria plan for the 2009 plan year.

Example 2. Director and employee. T is an em-ployee and also a director of Employer L, a C corpthat sponsors a cafeteria plan. The cafeteria plan al-lows only employees of Employer L to participate inthe cafeteria plan. T’s annual compensation as an em-ployee is $50,000; T is also paid $3,000 annually indirector’s fees. T makes a timely election to salaryreduce $5,000 from his employee compensation fordependent care benefits. T makes no election withrespect to his compensation as a director. T may par-ticipate in the cafeteria plan in his capacity as an em-ployee of Employer L.

(3) Limits on participation by formeremployees. Although former employeesare treated as employees, a cafeteria planmay not be established or maintained pre-dominantly for the benefit of former em-ployees of the employer. Such a plan is nota cafeteria plan.

(4) No participation by the spouse ordependent of an employee. (i) Benefits al-lowed to participant’s spouse or depen-dents but not participation. The spouse ordependents of employees may not be par-ticipants in a cafeteria plan unless they arealso employees. However, a cafeteria planmay provide benefits to spouses and de-pendents of participants. For example, al-though an employee’s spouse may benefitfrom the employee’s election of accidentand health insurance coverage or of cov-erage through a dependent care assistanceprogram, the spouse may not participate ina cafeteria plan (that is, the spouse may notbe given the opportunity to elect or pur-chase benefits offered by the plan).

(ii) Certain elections after employee’sdeath. An employee’s spouse is not a par-ticipant in a cafeteria plan merely becausethe spouse has the right, upon the death ofthe employee, to elect among various set-tlement options or to elect among permis-sible distribution options with respect tothe deceased employee’s benefits through

a section 401(k) plan, Health Savings Ac-count, or certain group-term life insuranceoffered through the cafeteria plan. See§54.4980B–2, Q & A 8 and §54.4980B–4,Q & A–1 of this chapter on COBRA rightsof a participant’s spouse or dependents.

(5) Employees of certain controlledgroups. All employees who are treatedas employed by a single employer undersection 414(b), (c), (m), or (o) are treatedas employed by a single employer for pur-poses of section 125. Section 125(g)(4);section 414(t).

(h) After-tax employee contribu-tions—(1) Certain after-tax employeecontributions treated as cash. In additionto the cash benefits described in paragraph(a)(2) of this section, in general, a benefitis treated as cash for purposes of section125 if the benefit does not defer compen-sation (except as provided in paragraph(o) of this section) and an employee whoreceives the benefit purchases such benefitwith after-tax employee contributions oris treated, for all purposes under the Code(including, for example, reporting andwithholding purposes), as receiving, atthe time that the benefit is received, cashcompensation equal to the full value of thebenefit at that time and then purchasingthe benefit with after-tax employee con-tributions. Thus, for example, long-termdisability coverage is treated as cash forpurposes of section 125 if the cafeteriaplan provides that an employee may pur-chase the coverage through the cafeteriaplan with after-tax employee contributionsor provides that the employee receivingsuch coverage is treated as having receivedcash compensation equal to the value ofthe coverage and then as having purchasedthe coverage with after-tax employee con-tributions. Also, for example, a cafeteriaplan may offer employees the opportu-nity to purchase, with after-tax employeecontributions, group-term life insuranceon the life of an employee (providingno permanent benefits), an accident andhealth plan, or a dependent care assistanceprogram.

(2) Accident and health coverage pur-chased for someone other than the em-ployee’s spouse or dependents with af-ter-tax employee contributions. If therequirements of section 106 are satisfied,employer-provided accident and healthcoverage for an employee and his or herspouse or dependents is excludible from

September 24, 2007 695 2007–39 I.R.B.

the employee’s gross income. The fairmarket value of coverage for any otherindividual, provided with respect to theemployee, is includible in the employee’sgross income. §1.106–1; §1.61–21(a)(4),and §1.61–21(b)(1). A cafeteria plan ispermitted to allow employees to elect acci-dent and health coverage for an individualwho is not the spouse or dependent of theemployee as a taxable benefit.

(3) Example. The following exampleillustrates the rules of this paragraph (h):

Example. Accident and health plan coverage forindividuals who are not a spouse or dependent of anemployee. (i) Employee C participates in EmployerM’s cafeteria plan. Employee C timely elects salaryreduction for employer-provided accident and healthcoverage for himself and for accident and health cov-erage for his former spouse. C’s former spouse is notC’s dependent. A former spouse is not a spouse asdefined in section 152.

(ii) The fair market value of the coverage for theformer spouse is $1,000. Employee C has $1,000 in-cludible in gross income for the accident and healthcoverage of his former spouse, because the section106 exclusion applies only to employer-provided ac-cident and health coverage for the employee or theemployee’s spouse or dependents.

(iii) No payments or reimbursements received un-der the accident and health coverage result in grossincome to Employee C or to the former spouse. Theresult is the same if the $1,000 for coverage of C’sformer spouse is paid from C’s after-tax income out-side the cafeteria plan.

(i) Prohibited taxable benefits. Anytaxable benefit not described in paragraph(a)(2) of this section and not treated as cashfor purposes of section 125 in paragraph(h) of this section is not permitted to be in-cluded in a cafeteria plan. A plan that of-fers taxable benefits other than the taxablebenefits 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 froman employee’s gross income when pro-vided separately, the benefit is excludiblefrom gross income when provided througha cafeteria plan. Thus, a qualified benefitis excludible from gross income if both therules under section 125 and the specificrules providing for the exclusion of thebenefit from gross income are satisfied.For example, if the nondiscriminationrules for specific qualified benefits (for ex-ample, sections 79(d), 105(h), 129(d)(2),137(c)(2)) are not satisfied, those qualifiedbenefits are includible in gross income.Thus, if $50,000 in group-term life insur-ance is offered through a cafeteria plan, thenondiscrimination rules in section 79(d)

must be satisfied in order to exclude thecoverage from gross income.

(2) Section 125 nondiscriminationrules. Qualified benefits are includiblein the gross income of highly compen-sated participants or key employees if thenondiscrimination rules of section 125 arenot satisfied. See §1.125–7.

(3) Taxable benefits. If a benefit that isincludible in gross income when offeredseparately is offered through a cafeteriaplan, the benefit continues to be includiblein gross income.

(k) Group-term life insurance—(1)In general. In addition to offering upto $50,000 in group-term life insurancecoverage excludible under section 79(a),a cafeteria plan may offer coverage inexcess of that amount. The cost of cov-erage in excess of $50,000 in group-termlife insurance coverage provided under apolicy or policies carried directly or indi-rectly by one or more employers (takinginto account all coverage provided boththrough a cafeteria plan and outside a cafe-teria plan) is includible in an employee’sgross income. Group-term life insurancecombined with permanent benefits, withinthe meaning of §1.79–0, is a prohibitedbenefit in a cafeteria plan.

(2) Determining cost of insurance in-cludible in employee’s gross income. (i)In general. If the aggregate group-termlife insurance coverage on the life of theemployee (under policies carried directlyor indirectly by the employer) exceeds$50,000, all or a portion of the insuranceis provided through a cafeteria plan, andthe group-term life insurance is providedthrough a plan that meets the nondis-crimination rules of section 79(d), theamount includible in an employee’s grossincome is determined under paragraphs(k)(2)(i)(A) through (C) of this section.For each employee—

(A) The entire amount of salary reduc-tion and employer flex-credits through acafeteria plan for group-term life insur-ance coverage on the life of the employeeis excludible from the employee’s grossincome, regardless of the amount of em-ployer-provided group-term life insuranceon the employee’s life (that is, whether ornot the coverage provided to the employeeboth through the cafeteria plan and outsidethe cafeteria plan exceeds $50,000);

(B) The cost of the group-term life in-surance in excess of $50,000 of cover-

age is includible in the employee’s grossincome. The amount includible in theemployee’s income is determined usingthe rules of §1.79–3 and Table I (Uni-form Premiums for $1,000 of Group-TermLife Insurance Protection). See subpara-graph (C) of this paragraph (k)(2)(i) fordetermining the amount paid by the em-ployee for purposes of reducing the Ta-ble I amount includible in income under§1.79–3.

(C) In determining the amount paid bythe employee toward the purchase of thegroup-term life insurance for purposes of§1.79–3, only an employee’s after-tax con-tributions are treated as an amount paid bythe employee.

(ii) Examples. The rules in this para-graph (k) are illustrated by the followingexamples, in which the group-term lifeinsurance coverage satisfies the nondis-crimination rules in section 79(d), providesno permanent benefits, is for a 12-monthperiod, is the only group-term life insur-ance coverage provided under a policy car-ried directly or indirectly by the employer,and applies Table I (Uniform Premiums for$1,000 of Group-Term Life Insurance Pro-tection) effective July 1, 1999:

Example 1. Excess group-term life insurance cov-erage provided through salary reduction in a cafete-ria plan. (i) Employer N provides group-term life in-surance coverage to its employees only through itscafeteria plan. Employer N’s cafeteria plan allowsemployees to elect salary reduction for group-termlife insurance. Employee B, age 42, elected salaryreduction of $200 for $150,000 of group-term life in-surance. None of the group-term life insurance is paidthrough after-tax employee contributions.

(ii) B’s $200 of salary reduction for group-termlife insurance is excludible from B’s gross incomeunder paragraph (k)(2)(i)(A).

(iii) B has a total of $150,000 of group-term lifeinsurance. The group-term life insurance in excessof the dollar limitation of section 79 is $100,000(150,000 - 50,000).

(iv) The Table I cost is $120 for $100,000 ofgroup-term life insurance for an individual betweenages 40 to 44. The Table I cost of $120 is reducedby zero (because B paid no portion of the group-termlife 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 forthe $100,000 of excess group-term life insurance is$120.

Example 2. Excess group-term life insurancecoverage provided through salary reduction in acafeteria plan where employee purchases a portionof group-term life insurance coverage with after-taxcontributions. (i) Same facts as Example 1, exceptthat B elected salary reduction of $100 and makes anafter-tax contribution of $100 toward the purchase ofgroup-term life insurance coverage.

2007–39 I.R.B. 696 September 24, 2007

(ii) B’s $100 of salary reduction for group-termlife insurance is excludible from B’s gross income,under paragraph (k)(2)(i)(A) of this section.


(iv) The Table I cost is $120 for $100,000 ofgroup-term life insurance for an individual betweenages 40 to 44, under paragraph (k)(2)(i)(B). TheTable I cost of $120 is reduced by $100 (becauseB paid $100 for the group-term life insurance withafter-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 incomefor the $100,000 of excess group-term life insurancecoverage is $20.

Example 3. Excess group-term life insurancecoverage provided through salary reduction in acafeteria plan and outside a cafeteria plan. (i) Samefacts as Example 1 except that Employer N alsoprovides (at no cost to employees) group-term lifeinsurance coverage equal to each employee’s annualsalary. Employee B’s annual salary is $150,000. Bhas $150,000 of group-term life insurance directlyfrom Employer N, and also $150,000 coveragethrough Employer N’s cafeteria plan.

(ii) B’s $200 of salary reduction for group-termlife insurance is excludible from B’s gross income,under paragraph (k)(2)(i)(A) of this section.


(iv) The Table I cost is $300 for $250,000 ofgroup-term life insurance for an individual betweenages 40 to 44. The Table I cost of $300 is reducedby zero (because B paid no portion of the group-termlife insurance with after-tax employee contributions),under paragraphs (k)(2)(i)(B) and (k)(2)(i)(C) of thissection.

(v) The amount includible in B’s gross income forthe $250,000 of excess group-term life insurance is$300.

Example 4. Excess group-term life insurance cov-erage provided through salary reduction in a cafete-ria plan and outside a cafeteria plan. (i) Same factsas Example 3 except that Employee C’s annual salaryis $30,000. C has $30,000 of group-term life insur-ance coverage provided directly from Employer N,and elects an additional $30,000 of coverage for $40through Employer N’s cafeteria plan. C is 42 yearsold.

(ii) C’s $40 of salary reduction for group-term lifeinsurance is excludible from C’s gross income, underparagraph (k)(2)(i)(A) of this section.

(iii) C has a total of $60,000 of group-term lifeinsurance. The group-term life insurance in excess ofthe 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 40to 44. The Table I cost of $12 is reduced by zero(because C paid no portion of the group-term life in-surance with after-tax employee contributions), underparagraphs (k)(2)(i)(B) and (k)(2)(i)(C) of this sec-tion.

(v) The amount includible in C’s gross incomefor the $10,000 of excess group-term life insurancecoverage is $12.

(l) COBRA premiums—(1) PayingCOBRA premiums through a cafeteriaplan. Under §1.125–4(c)(3)(iv), COBRApremiums for an employer-provided grouphealth plan are qualified benefits if:

(i) The premiums are excludible froman employee’s income under section 106;or

(ii) The premiums are for the accidentand health plan of the employer spon-soring the cafeteria plan, even if the fairmarket value of the premiums is includi-ble in an employee’s gross income. Seealso paragraph (e)(2) in §1.125–5 and§54.4980B–2, Q & A–8 of this chapter forCOBRA rules for health FSAs.

(2) Example. The following exampleillustrates the rules of this paragraph (l):

Example. COBRA premiums. (i) Employer Omaintains a cafeteria plan for full-time employees,offering an election between cash and employer-pro-vided accident and health insurance and other quali-fied benefits. Employees A, B, and C participate inthe cafeteria plan. On July 1, 2009, Employee A hasa qualifying event (as defined in §54.4980B–4 of thischapter).

(ii) Employee A was a full-time employee and be-came a part-time employee and for that reason, is nolonger covered by Employer O’s accident and healthplan. Under §1.125–4(f)(3)(ii), Employee A changesher election to salary reduce to pay her COBRA pre-miums.

(iii) Employee B previously worked for anotheremployer, quit and elected COBRA. Employee B be-gins work for Employer O on July 1, 2009, and be-comes eligible to participate in Employer O’s cafe-teria plan on July 1, 2009, but will not be eligible toparticipate in Employer O’s accident and health planuntil October 1, 2009. Employee B elects to salaryreduce to pay COBRA premiums for coverage underthe accident and health plan sponsored by B’s formeremployer.

(iv) Employee C and C’s spouse are covered byEmployer O’s accident and health plan until July 1,2009, when C’s divorce from her spouse becamefinal. C continues to be covered by the accidentand health plan. On July 1, 2009, C requests to payCOBRA premiums for her former spouse (who isnot C’s dependent (as defined in section 152)) withafter-tax employee contributions.

(v) Salary reduction elections for COBRA premi-ums for Employees A and B are qualified benefits forpurposes of section 125 and are excludible from thegross income of Employees A and B. Employer O al-lows A and B to salary reduce for these COBRA pre-miums.

(vi) Employer O allows C to pay for COBRApremiums for C’s former spouse, with after-tax em-ployee contributions because although accident andhealth coverage for C’s former spouse is permitted ina cafeteria plan, the premiums are includible in C’sgross income.

(vii) The operation of Employer O’s cafeteriaplan satisfies the requirements of this paragraph (l).

(m) Payment or reimbursement of em-ployees’ individual accident and health in-surance premiums—(1) In general. Thepayment or reimbursement of employees’substantiated individual health insurancepremiums is excludible from employees’gross income under section 106 and is aqualified benefit for purposes of section125.

(2) Example. The following exampleillustrates the rule of this paragraph (m):

Example. Payment or reimbursement of premi-ums. (i) Employer P’s cafeteria plan offers the fol-lowing benefits for employees who are covered byan individual health insurance policy. The employeesubstantiates the expenses for the premiums for thepolicy (as required in paragraph (b)(2) in §1.125–6)before any payments or reimbursements to the em-ployee for premiums are made. The payments or re-imbursements are made in the following ways:

(ii) The cafeteria plan reimburses each employeedirectly for the amount of the employee’s substanti-ated health insurance premium;

(iii) The cafeteria plan issues the employee acheck payable to the health insurance company forthe amount of the employee’s health insurance pre-mium, which the employee is obligated to tender tothe insurance company;

(iv) The cafeteria plan issues a check in the samemanner as (iii), except that the check is payablejointly to the employee and the insurance company;or

(v) Under these circumstances, the individualhealth insurance policies are accident and healthplans as defined in §1.106–1. This benefit is a quali-fied benefit under section 125.

(n) Section 105 rules for accident andhealth plan offered through a cafeteriaplan—(1) General rule. In order for anaccident and health plan to be a qualifiedbenefit that is excludible from gross in-come if elected through a cafeteria plan,the cafeteria plan must satisfy section 125and the accident and health plan must sat-isfy section 105(b) and (h).

(2) Section 105(b) requirements in gen-eral. Section 105(b) provides an exclusionfrom gross income for amounts paid toan employee from an employer-fundedaccident and health plan specifically toreimburse the employee for certain ex-penses for medical care (as defined insection 213(d)) incurred by the employeeor the employee’s spouse or dependentsduring the period for which the benefit isprovided to the employee (that is, whenthe employee is covered by the accidentand health plan).

(o) Prohibition against deferred com-pensation—(1) In general. Any plan that

September 24, 2007 697 2007–39 I.R.B.

offers a benefit that defers compensa-tion (except as provided in this paragraph(o)) is not a cafeteria plan. See section125(d)(2)(A). A plan that permits em-ployees to carry over unused electivecontributions, after-tax contributions, orplan benefits from one plan year to an-other (except as provided in paragraphs(e), (o)(3) and (4) and (p) of this sec-tion) defers compensation. This is thecase regardless of how the contributionsor benefits are used by the employee inthe subsequent plan year (for example,whether they are automatically or elec-tively converted into another taxable ornontaxable benefit in the subsequent planyear or used to provide additional benefitsof the same type). Similarly, a cafeteriaplan also defers compensation if the planpermits employees to use contributions forone plan year to purchase a benefit thatwill be provided in a subsequent plan year(for example, life, health or disability ifthese benefits have a savings or investmentfeature, such as whole life insurance). Seealso Q & A–5 in §1.125–3, prohibiting de-ferring compensation from one cafeteriaplan year to a subsequent cafeteria planyear. See paragraph (e) of this section forgrace period rules. A plan does not defercompensation merely because it allocatesexperience gains (or forfeitures) amongparticipants in compliance with paragraph(o) in §1.125–5.

(2) Effect if a plan includes a benefitthat defers the receipt of compensation ora plan operates to defer compensation. Ifa plan violates paragraph (o)(1) of this sec-tion, the availability of an election betweentaxable and nontaxable benefits under sucha plan results in gross income to the em-ployees.

(3) Cash or deferred arrangements thatmay be offered in a cafeteria plan. (i) Ingeneral. A cafeteria plan may offer thebenefits set forth in this paragraph (o)(3),even though these benefits defer compen-sation.

(ii) Elective contributions to a section401(k) plan. A cafeteria plan may permita covered employee to elect to have theemployer, on behalf of the employee, payamounts as contributions to a trust that ispart of a profit-sharing or stock bonus planor rural cooperative plan (within the mean-ing of section 401(k)(7)), which includes aqualified cash or deferred arrangement (asdefined in section 401(k)(2)). In addition,

after-tax employee contributions under aqualified plan subject to section 401(m)are permitted through a cafeteria plan. Theright to make such contributions does notcause a plan to fail to be a cafeteria planmerely because, under the qualified plan,employer matching contributions (as de-fined in section 401(m)(4)(A)) are madewith respect to elective or after-tax em-ployee contributions.

(iii) Additional permitted deferred com-pensation arrangements. A plan main-tained by an educational organization de-scribed in section 170(b)(1)(A)(ii) to theextent of amounts which a covered em-ployee may elect to have the employer payas contributions for post-retirement grouplife insurance is permitted through a cafe-teria plan, if—

(A) All contributions for such insurancemust be made before retirement; and

(B) Such life insurance does not have acash surrender value at any time.

(iv) Contributions to HSAs. Contribu-tions to covered employees’ HSAs as de-fined in section 223 (but not contributionsto Archer MSAs).

(4) Paid time off. (i) In general. A cafe-teria plan is permitted to include electivepaid time off (that is, vacation days, sickdays or personal days) as a permitted tax-able benefit through the plan by permit-ting employees to receive more paid timeoff than the employer otherwise providesto the employees on a nonelective basis,but only if the inclusion of elective paidtime off through the plan does not operateto permit the deferral of compensation. Inaddition, a plan that only offers the choiceof cash or paid time off is not a cafete-ria plan and is not subject to the rules ofsection 125. In order to avoid deferral ofcompensation, the cafeteria plan must pre-clude any employee from using the paidtime off or receiving cash, in a subsequentplan year, for any portion of such paid timeoff remaining unused as of the end of theplan year. (See paragraph (o)(4)(iii) of thissection for the deadline to cash out unusedelective paid time off.) For example, a planthat offers employees the opportunity topurchase paid time off (or to receive cashor other benefits through the plan in lieu ofpaid time off) is not a cafeteria plan if em-ployees who purchase the paid time off fora plan year are allowed to use any unusedpaid time off in a subsequent plan year.This is the case even though the plan does

not permit the employee to convert, in anysubsequent plan year, the unused paid timeoff into any other benefit.

(ii) Ordering of elective and nonelec-tive paid time off. In determining whethera plan providing paid time off operatesto permit the deferral of compensation, acafeteria plan must provide that employeesare deemed to use paid time off in the fol-lowing order:

(A) Nonelective paid time off. Nonelec-tive paid time off (that is, paid time off withrespect to which the employee has no elec-tion) is used first;

(B) Elective paid time off. Elective paidtime off is used after all nonelective paidtime off is used.

(iii) Cashing out or forfeiture of un-used elective paid time off, in general. Thecafeteria plan must provide that all unusedelective paid time off (determined as of thelast day of the plan year) must either bepaid in cash (within the time specified inthis paragraph (o)(4)) or be forfeited. Thisprovision must apply uniformly to all par-ticipants in the cafeteria plan.

(A) Cash out of unused elective paidtime off. A plan does not operate to permitthe deferral of compensation merely be-cause the plan provides that an employeewho has not used all elective paid time offfor a plan year receives in cash the valueof such unused paid time off. The em-ployee must receive the cash on or beforethe last day of the cafeteria plan’s plan yearto which the elective contributions used topurchase the unused elective paid time offrelate.

(B) Forfeiture of unused elective paidtime off. If the cafeteria plan provides forforfeiture of unused elective paid time off,the forfeiture must be effective on the lastday of the plan year to which the electivecontributions relate.

(iv) No grace period for paid time off.The grace period described in paragraph(e) of this section does not apply to paidtime off.

(v) Examples. The following examplesillustrate the rules of this paragraph (o)(4):

Example 1. Plan cashes out unused elective paidtime off on or before the last day of the plan year. (i)Employer Q provides employees with two weeks ofpaid time off for each calendar year. Employer Q’shuman resources policy (that is, outside the cafeteriaplan), permits employees to carry over one nonelec-tive week of paid time off to the next year. EmployerQ maintains a calendar year cafeteria plan that per-

2007–39 I.R.B. 698 September 24, 2007

mits the employee to purchase, with elective contri-butions, an additional week of paid time off.

(ii) For the 2009 plan year, Employee A (with acalendar tax year), timely elects to purchase one addi-tional week of paid time off. During 2009, EmployeeA uses only two weeks of paid time off. EmployeeA is deemed to have used two weeks of nonelectivepaid time off and zero weeks of elective paid time off.

(iii) Pursuant to the cafeteria plan, the plan paysEmployee A the value of the unused elective paidtime off week in cash on December 31, 2009. Em-ployer Q includes this amount on the 2009 Form W–2for Employee A. This amount is included in Em-ployee A’s gross income in 2009. The cafeteria plan’sterms and operations do not violate the prohibitionagainst deferring compensation.

Example 2. Unused nonelective paid time off car-ried over to next plan year. (i) Same facts as Exam-ple 1, except that Employee A uses only one week ofpaid time off during the year. Pursuant to the cafeteriaplan, Employee A is deemed to have used one non-elective week, and having retained one nonelectiveweek and one elective week of paid time off. Em-ployee A receives in cash the value of the unusedelective paid time off on December 31, 2009. Em-ployer Q includes this amount on the 2009 Form W–2for Employee A. Employee A must report this amountas gross income in 2009.

(ii) Pursuant to Employer Q’s human resourcespolicy, Employee A is permitted to carry over the onenonelective week of paid time off to the next year.Nonelective paid time off is not part of the cafeteriaplan (that is, neither Employer Q nor the cafeteriaplan permit employees to exchange nonelective paidtime off for other benefits).

(iii) The cafeteria plan’s terms and operations donot violate the prohibition against deferring compen-sation.

Example 3. Forfeiture of unused elective paidtime off. Same facts as Example 2, except that pur-suant to the cafeteria plan, Employee A forfeits theremaining one week of elective paid time off. Thecafeteria plan’s terms and operations do not violatethe prohibition against deferring compensation.

Example 4. Unused elective paid time off carriedover to next plan year. Same facts as Example 1,except that Employee A uses only two weeks of paidtime off during the 2009 plan year, and, under theterms of the cafeteria plan, Employee A is treated ashaving used the two nonelective weeks and as havingretained the one elective week. The one remainingweek (that is, the elective week) is carried over to thenext plan year (or the value thereof used for any otherpurpose in the next plan year). The plan operates topermit deferring compensation and is not a cafeteriaplan.

Example 5. Paid time off exchanged for accidentand health insurance premiums. Employer R pro-vides employees with four weeks of paid time off fora year. Employer R’s calendar year cafeteria planpermits employees to exchange up to one week ofpaid time off to pay the employee’s share of accidentand health insurance premiums. For the 2009 planyear, Employee B (with a calendar tax year), timelyelects to exchange one week of paid time off (valuedat $769) to pay accident and health insurance premi-ums for 2009. The $769 is excludible from EmployeeB’s gross income under section 106. The cafeteria

plan’s terms and operations do not violate the prohi-bition against deferring compensation.

(p) Benefits relating to more than oneyear—(1) Benefits in an accident andhealth insurance policy relating to morethan one year. Consistent with section125(d), an accident and health insurancepolicy may include certain benefits, asset forth in this paragraph (p)(1), withoutviolating the prohibition against deferredcompensation.

(i) Permitted benefits. The followingfeatures or benefits of insurance policiesdo not defer compensation—

(A) Credit toward the deductible for un-reimbursed covered expenses incurred inprior periods;

(B) Reasonable lifetime maximum limiton benefits;

(C) Level premiums;(D) Premium waiver during disability;(E) Guaranteed policy renewability of

coverage, without further evidence of in-surability (but not guaranty of the amountof premium upon renewal);

(F) Coverage for a specified accidentalinjury;

(G) Coverage for a specified disease orillness, including payments at initial diag-nosis of the specified disease or illness,and progressive payments of a set amountper month following the initial diagnosis(sometimes referred to as progressive di-agnosis payments); and

(H) Payment of a fixed amount per day(or other period) of hospitalization.

(ii) Requirements of permitted bene-fits. All benefits described in paragraph(p)(1)(i) of this section must in additionsatisfy all of the following requirements—

(A) No part of any benefit is used inone plan year to purchase a benefit in asubsequent plan year;

(B) The policies remain in force only solong as premiums are timely paid on a cur-rent basis, and, irrespective of the amountof premiums paid in prior plan years, if thecurrent premiums are not paid, all cover-age for new diseases or illnesses lapses.See paragraph (p)(1)(i)(D), allowing pre-mium waiver during disability;

(C) There is no investment fund or cashvalue to rely upon for payment of premi-ums; and

(D) No part of any premium is held ina separate account for any participant orbeneficiary, or otherwise segregated fromthe assets of the insurance company.

(2) Benefits under a long-term disabil-ity policy relating to more than one year.A long-term disability policy paying dis-ability benefits over more than one yeardoes not violate the prohibition against de-ferring compensation.

(3) Reasonable premium rebates or pol-icy dividends. Reasonable premium re-bates or policy dividends paid with re-spect to benefits provided through a cafe-teria plan do not constitute impermissi-ble deferred compensation if such rebatesor dividends are paid before the close ofthe 12-month period immediately follow-ing the cafeteria plan year to which suchrebates and dividends relate.

(4) Mandatory two-year election for vi-sion or dental insurance. When a cafeteriaplan offers vision or dental insurance thatrequires a mandatory two-year coverageperiod, but not longer (sometimes referredto as a “two-year lock-in”), the mandatorytwo-year coverage period does not result indeferred compensation in violation of sec-tion 125(d)(2), provided both of the fol-lowing requirements are satisfied—

(i) The premiums for each plan year arepaid no less frequently than annually; and

(ii) In no event does a cafeteria planuse salary reduction or flex-credits relatingto the first year of a two-year election toapply to vision or dental insurance for thesecond year of the two-year election.

(5) Using salary reduction amountsfrom one plan year to pay accident andhealth insurance premiums for the firstmonth of the immediately following planyear.

(i) In general. Salary reductionamounts from the last month of one planyear of a cafeteria plan may be applied topay accident and health insurance premi-ums for insurance during the first monthof the immediately following plan year,if done on a uniform and consistent basiswith respect to all participants (based onthe usual payroll interval for each groupof participants).

(ii) Example. The following example il-lustrates the rules in this paragraph (p)(5):

Example. Salary reduction payments in Decem-ber of calendar plan year to pay accident and healthinsurance premiums for January. Employer S main-tains a calendar year cafeteria plan. The cafeteria planoffers employees a salary reduction election for ac-cident and health insurance. The plan provides thatemployees’ salary reduction amounts for the last payperiod in December are applied to pay accident andhealth insurance premiums for the immediately fol-

September 24, 2007 699 2007–39 I.R.B.

lowing January. All employees are paid bi-weekly.For the plan year ending December 31, 2009, Em-ployee C elects salary reduction of $3,250 for acci-dent and health coverage. For the last pay periodin December 2009, $125 (3,250/26) is applied to theaccident and health insurance premium for January2010. This plan provision does not violate the prohi-bition against deferring compensation.

(q) Nonqualified benefits—(1) In gen-eral. The following benefits are nonqual-ified benefits that are not permitted to beoffered in a cafeteria plan—

(i) Scholarships described in section117;

(ii) Employer-provided meals and lodg-ing described in section 119;

(iii) Educational assistance described insection 127;

(iv) Fringe benefits described in section132;

(v) Long-term care insurance, or anyproduct which is advertised, marketed oroffered as long-term care insurance;

(vi) Long-term care services (but seeparagraph (q)(3) of this section);

(vii) Group-term life insurance on thelife of any individual other than an em-ployee (whether includible or excludiblefrom the employee’s gross income);

(viii) Health reimbursement arrange-ments (HRAs) that provide reimburse-ments up to a maximum dollar amountfor a coverage period and that all or anyunused amount at the end of a coverageperiod is carried forward to increase themaximum reimbursement amount in sub-sequent coverage periods;

(ix) Contributions to Archer MSAs(section 220); and

(x) Elective deferrals to a section 403(b)plan.

(2) Nonqualified benefits not permit-ted in a cafeteria plan. The benefits de-scribed in this paragraph (q) are not qual-ified benefits or taxable benefits or cashfor purposes of section 125 and thus maynot be offered in a cafeteria plan regard-less of whether any such benefit is pur-chased with after-tax employee contribu-tions or on any other basis. A plan that of-fers a nonqualified benefit is not a cafeteriaplan. Employees’ elections between tax-able and nontaxable benefits through suchplan result in gross income to the partici-pants for any benefit elected. See section125(f). See paragraph (q)(3) of this sec-tion for special rule on long-term care in-surance purchased through an HSA.

(3) Long-term care insurance or ser-vices purchased through an HSA. Al-though long-term care insurance is not aqualified benefit and may not be offered ina cafeteria plan, a cafeteria plan is permit-ted to offer an HSA as a qualified benefit,and funds from the HSA may be usedto pay eligible long-term care premiumson a qualified long-term care insurancecontract or for qualified long-term careservices.

(r) Employer contributions to a cafete-ria plan—(1) Salary reduction-in general.The term employer contributions meansamounts that are not currently available(after taking section 125 into account) tothe employee but are specified in the cafe-teria plan as amounts that an employeemay use for the purpose of electing ben-efits through the plan. A plan may providethat employer contributions may be made,in whole or in part, pursuant to employ-ees’ elections to reduce their compensationor to forgo increases in compensation andto have such amounts contributed, as em-ployer contributions, by the employer ontheir behalf. See also §1.125–5 (flexiblespending arrangements). Also, a cafeteriaplan is permitted to require employees toelect to pay the employees’ share of anyqualified benefit through salary reductionand not with after-tax employee contribu-tions. A cafeteria plan is also permitted topay reasonable cafeteria plan administra-tive fees through salary reduction amounts,and these salary reduction amounts are ex-cludible from an employee’s gross income.

(2) Salary reduction as employer con-tribution. Salary reduction contributionsare employer contributions. An em-ployee’s salary reduction election is anelection to receive a contribution by theemployer in lieu of salary or other com-pensation that is not currently availableto the employee as of the effective dateof the election and that does not subse-quently become currently available to theemployee.

(3) Employer flex-credits. A cafeteriaplan may also provide that the employercontributions will or may be made on be-half of employees equal to (or up to) spec-ified amounts (or specified percentages ofcompensation) and that such nonelectivecontributions are available to employeesfor the election of benefits through theplan.

(4) Elective contributions to a section401(k) plan. See §1.401(k)–1 for generalrules relating to contributions to section401(k) plans.

(s) Effective/applicability date. It isproposed that these regulations apply onand after plan years beginning on or af-ter January 1, 2009, except that the rule inparagraph (k)(2)(i)(B) of this section is ef-fective as of the date the proposed regula-tions are published in the Federal Regis-ter.

§1.125–2 Cafeteria plans; elections.

(a) Rules relating to making and revok-ing elections—(1) Elections in general. Aplan is not a cafeteria plan unless the planprovides in writing that employees are per-mitted to make elections among the per-mitted taxable benefits and qualified ben-efits offered through the plan for the planyear (and grace period, if applicable). Allelections must be irrevocable by the datedescribed in paragraph (a)(2) of this sec-tion except as provided in paragraph (a)(4)of this section. An election is not irrevo-cable if, after the earlier of the dates speci-fied in paragraph (a)(2) of this section, em-ployees have the right to revoke their elec-tions of qualified benefits and instead re-ceive the taxable benefits for such period,without regard to whether the employeesactually revoke their elections.

(2) Timing of elections. In order foremployees to exclude qualified benefitsfrom employees’ gross income, benefitelections in a cafeteria plan must be madebefore the earlier of—

(i) The date when taxable benefits arecurrently available; or

(ii) The first day of the plan year (orother coverage period).

(3) Benefit currently available to an em-ployee-in general. Cash or another taxablebenefit is currently available to the em-ployee if it has been paid to the employeeor if the employee is able currently to re-ceive the cash or other taxable benefit atthe employee’s discretion. However, cashor another taxable benefit is not currentlyavailable to an employee if there is a sig-nificant limitation or restriction on the em-ployee’s right to receive the benefit cur-rently. Similarly, a benefit is not currentlyavailable as of a date if the employee mayunder no circumstances receive the benefitbefore a particular time in the future. The

2007–39 I.R.B. 700 September 24, 2007

determination of whether a benefit is cur-rently available to an employee does notdepend on whether it has been construc-tively received by the employee for pur-poses of section 451.

(4) Exceptions to rule on making andrevoking elections. If a cafeteria plan in-corporates the change in status rules in§1.125–4, to the extent provided in thoserules, an employee who experiences achange in status (as defined in §1.125–4)is permitted to revoke an existing electionand to make a new election with respectto the remaining portion of the period ofcoverage, but only with respect to cash orother taxable benefits that are not yet cur-rently available. See paragraph (c)(1) ofthis section for a special rule for changingelections prospectively for HSA contri-butions and paragraph (r)(4) in §1.125–1for section 401(k) elections. Also, onlyan employee of the employer sponsoring acafeteria plan is allowed to make, revokeor change elections in the employer’scafeteria plan. The employee’s spouse,dependent or any other individual otherthan the employee may not make, revokeor change elections under the plan.

(5) Elections not required on writtenpaper documents. A cafeteria plan doesnot fail to meet the requirements of section125 merely because it permits employeesto use electronic media for such transac-tions. The safe harbor in §1.401(a)–21 ap-plies to electronic elections, revocationsand changes in elections under section 125.

(6) Examples. The following examplesillustrate the rules in this paragraph (a):

Example 1. Election not revocable during planyear. Employer A’s cafeteria plan offers each em-ployee the opportunity to elect, for a plan year,between $5,000 cash for the plan year and a de-pendent care assistance program of up to $5,000 ofdependent care expenses incurred by the employeeduring the plan year. The cafeteria plan requiresemployees to elect between these benefits before thebeginning of the plan year. After the year has com-menced, employees are prohibited from revokingtheir elections. The cafeteria plan allows revocationof elections based on changes in status (as describedin §1.125–4). Employees who elected the dependentcare assistance program do not include the $5,000cash in gross income. The cafeteria plan satisfies therequirements in this paragraph (a).

Example 2. Election revocable during plan year.Same facts as Example 1 except that Employer A’scafeteria plan allows employees to revoke their elec-tions for dependent care assistance at any time dur-ing the plan year and receive the unused amount ofdependent care assistance as cash. The cafeteria planfails to satisfy the requirements in this paragraph (a),and is not a cafeteria plan. All employees are treated

as having received the $5,000 in cash even if theydo not revoke their elections. The same result occurseven though the cash is not payable until the end ofthe plan year.

(b) Automatic elections—(1) In gen-eral. For new employees or current em-ployees who fail to timely elect betweenpermitted taxable benefits and qualifiedbenefits, a cafeteria plan is permitted, butis not required, to provide default electionsfor one or more qualified benefits (for ex-ample, an election made for any prior yearis deemed to be continued for every suc-ceeding plan year, unless changed).

(2) Example. The following exampleillustrates the rules in this paragraph (b):

Example. Automatic elections for accident andhealth insurance. (i) Employer B maintains a cal-endar year cafeteria plan. The cafeteria plan offersaccident and health insurance with an option for em-ployee-only or family coverage. All employees areeligible to participate in the cafeteria plan immedi-ately upon hire.

(ii) The cafeteria plan provides for an automaticenrollment process: each new employee and eachcurrent employee is automatically enrolled in em-ployee-only coverage under the accident and healthinsurance plan, and the employee’s salary is reducedto pay the employee’s share of the accident andhealth insurance premium, unless the employee affir-matively elects cash. Alternatively, if the employeehas a spouse or child, the employee can elect familycoverage.

(iii) When an employee is hired, the employee re-ceives a notice explaining the automatic enrollmentprocess and the employee’s right to decline coverageand have no salary reduction. The notice includes thesalary reduction amounts for employee-only cover-age and family coverage, procedures for exercisingthe right to decline coverage, information on the timeby which an election must be made, and the periodfor which an election is effective. The notice is alsogiven to each current employee before the beginningof each subsequent plan year, except that the noticefor a current employee includes a description of theemployee’s existing coverage, if any.

(iv) For a new employee, an election to receivecash or to have family coverage rather than em-ployee-only coverage is effective if made whenthe employee is hired. For a current employee, anelection is effective if made prior to the start ofeach calendar year or under any other circumstancespermitted under §1.125–4. An election made forany prior year is deemed to be continued for everysucceeding plan year, unless changed.

(v) Contributions used to purchase accident andhealth insurance through a cafeteria plan are not in-cludible in the gross income of the employee solelybecause the plan provides for automatic enrollmentas a default election whereby the employee’s salaryis reduced each year to pay for a portion of the acci-dent and health insurance through the plan (unless theemployee affirmatively elects cash).

(c) Election rules for salary reductioncontributions to HSAs—(1) Prospectiveelections and changes in salary reduc-

tion elections allowed. Contributions maybe made to an HSA through a cafeteriaplan. A cafeteria plan offering HSA con-tributions through salary reduction maypermit employees to make prospectivesalary reduction elections or change orrevoke salary reduction elections for HSAcontributions (for example, to increaseor decrease salary reduction elections forHSA contributions) at any time during theplan year, effective before salary becomescurrently available. If a cafeteria planoffers HSA contributions as a qualifiedbenefit, the plan must—

(i) Specifically describe the HSA con-tribution benefit;

(ii) Allow a participant to prospectivelychange his or her salary reduction electionfor HSA contributions on a monthly basis(or more frequently); and

(iii) Allow a participant who becomesineligible to make HSA contributions toprospectively revoke his or her salary re-duction election for HSA contributions.

(2) Example. The following exampleillustrates the rules in this paragraph (c):

Example. Prospective HSA salary reduction elec-tions. (i) A cafeteria plan with a calendar plan yearallows employees to make salary reduction electionsfor HSA contributions through the plan. The cafe-teria plan permits employees to prospectively make,change or revoke salary contribution elections forHSA contributions, limited to one election, changeor revocation per month.

(ii) Employee M participates in the cafeteria plan.Before salary becomes currently available to M, Mmakes the following elections. On January 2, 2009,M elects to contribute $100 for each pay period to anHSA, effective January 3, 2009. On March 15, 2009,M elects to reduce the HSA contribution to $35 perpay period, effective April 1, 2009. On May 1, 2009,M elects to discontinue all HSA contributions, effec-tive May 15, 2009. The cafeteria plan implements allof Employee M’s elections,

(iii) The cafeteria plan’s operation is consistentwith the section 125 election, change and revocationrules for HSA contributions.

(d) Optional election for new employ-ees. A cafeteria plan may provide newemployees 30 days after their hire date tomake elections between cash and qualifiedbenefits. The election is effective as of theemployee’s hire date. However, salary re-duction amounts used to pay for such anelection must be from compensation notyet currently available on the date of theelection. The written cafeteria plan mustprovide that any employee who terminatesemployment and is rehired within 30 daysafter terminating employment (or who re-turns to employment following an unpaid

September 24, 2007 701 2007–39 I.R.B.

leave of absence of less than 30 days) is nota new employee eligible for the election inthis paragraph (d).

(e) Effective/applicability date. It isproposed that these regulations apply onand after plan years beginning on or afterJanuary 1, 2009.

Par. 3. Sections 1.125–5, 1.125–6 and1.125–7 are added to read as follows:

§1.125–5 Flexible spendingarrangements.

(a) Definition of flexible spending ar-rangement—(1) In general. An FSAgenerally is a benefit program that pro-vides employees with coverage whichreimburses specified, incurred expenses(subject to reimbursement maximums andany other reasonable conditions). Anexpense for qualified benefits must notbe reimbursed from the FSA unless itis incurred during a period of coverage.See paragraph (e) of this section. Afteran expense for a qualified benefit hasbeen incurred, the expense must first besubstantiated before the expense is reim-bursed. See paragraphs (a) through (f) in§1.125–6.

(2) Maximum amount of reimburse-ment. The maximum amount of reim-bursement that is reasonably availableto an employee for a period of coveragemust not be substantially in excess ofthe total salary reduction and employerflex-credit for such participant’s coverage.A maximum amount of reimbursementis not substantially in excess of the totalsalary reduction and employer flex-creditif such maximum amount is less than 500percent of the combined salary reductionand employer flex-credit. A single FSAmay provide participants with differentlevels of coverage and maximum amountsof reimbursement. See paragraph (r) in§1.125–1 and paragraphs (b) and (d) inthis section for the definition of salaryreduction, employer flex-credit, and uni-form coverage rule.

(b) Flex-credits allowed—(1) In gen-eral. An FSA in a cafeteria plan must in-clude an election between cash or taxablebenefits (including salary reduction) andone or more qualified benefits, and mayinclude, in addition, “employer flex-cred-its.” For this purpose, flex-credits are non-elective employer contributions that theemployer makes for every employee eligi-

ble to participate in the employer’s cafete-ria plan, to be used at the employee’s elec-tion only for one or more qualified benefits(but not as cash or a taxable benefit). See§1.125–1 for definitions of qualified bene-fits, cash and taxable benefits.

(2) Example. The following exampleillustrates the rules in this paragraph (b):

Example. Flex-credit. Contribution to healthFSA for employees electing employer-provided ac-cident and health plan. Employer A maintains acafeteria plan offering employees an election be-tween cash or taxable benefits and premiums foremployer-provided accident and health insurance orcoverage through an HMO. The plan also providesan employer contribution of $200 to the health FSAof every employee who elects accident and healthinsurance or HMO coverage. In addition, theseemployees may elect to reduce their salary to makeadditional contributions to their health FSAs. Thebenefits offered in this cafeteria plan are consistentwith the requirements of section 125 and this para-graph (b).

(c) Use-or-lose rule—(1) In general.An FSA may not defer compensation. Nocontribution or benefit from an FSA maybe carried over to any subsequent planyear or period of coverage. See paragraph(k)(3) in this section for specific excep-tions. Unused benefits or contributions re-maining at the end of the plan year (or atthe end of a grace period, if applicable) areforfeited.

(2) Example. The following exampleillustrates the rules in this paragraph (c):

Example. Use-or-lose rule. (i) Employer B main-tains a calendar year cafeteria plan, offering an elec-tion between cash and a health FSA. The cafeteriaplan has no grace period.

(ii) Employee A plans to have eye surgery in2009. For the 2009 plan year, Employee A timelyelects salary reduction of $3,000 for a health FSA.During the 2009 plan year, Employee A learns thatshe cannot have eye surgery performed, but in-curs other section 213(d) medical expenses totaling$1,200. As of December 31, 2009, she has $1,800 ofunused benefits and contributions in the health FSA.Consistent with the rules in this paragraph (c), sheforfeits $1,800.

(d) Uniform coverage rules applicableto health FSAs—(1) Uniform coveragethroughout coverage period—in general.The maximum amount of reimbursementfrom a health FSA must be available atall times during the period of coverage(properly reduced as of any particular timefor prior reimbursements for the sameperiod of coverage). Thus, the maximumamount of reimbursement at any particulartime during the period of coverage cannotrelate to the amount that has been con-tributed to the FSA at any particular timeprior to the end of the plan year. Similarly,

the payment schedule for the requiredamount for coverage under a health FSAmay not be based on the rate or amount ofcovered claims incurred during the cover-age period. Employees’ salary reductionpayments must not be accelerated basedon employees’ incurred claims and reim-bursements.

(2) Reimbursement available at alltimes. Reimbursement is deemed to beavailable at all times if it is paid at leastmonthly or when the total amount of theclaims to be submitted is at least a spec-ified, reasonable minimum amount (forexample, $50).

(3) Terminated participants. When anemployee ceases to be a participant, thecafeteria plan must pay the former partic-ipant any amount the former participantpreviously paid for coverage or benefits tothe extent the previously paid amount re-lates to the period from the date the em-ployee ceases to be a participant throughthe end of that plan year. See paragraph(e)(2) in this section for COBRA electionsfor health FSAs.

(4) Example. The following exampleillustrates the rules in this paragraph (d):

Example. Uniform coverage. (i) Employer Cmaintains a calendar year cafeteria plan, offering anelection between cash and a health FSA. The cafeteriaplan prohibits accelerating employees’ salary reduc-tion payments based on employees’ incurred claimsand reimbursements.

(ii) For the 2009 plan year, Employee N timelyelects salary reduction of $3,000 for a health FSA.Employee N pays the $3,000 salary reduction amountthrough salary reduction of $250 per month through-out the coverage period. Employee N is eligible toreceive the maximum amount of reimbursement of$3,000 at all times throughout the coverage period(reduced by prior reimbursements).

(iii) N incurs $2,500 of section 213(d) medicalexpenses in January, 2009. The full $2,500 is re-imbursed although Employee N has made only onesalary reduction payment of $250. N incurs $500 inmedical expenses in February, 2009. The remaining$500 of the $3,000 is reimbursed. After Employee Nsubmits a claim for reimbursement and substantiatesthe medical expenses, the cafeteria plan reimburses Nfor the $2,500 and $500 medical expenses. EmployerC’s cafeteria plan satisfies the uniform coverage rule.

(5) No uniform coverage rule for FSAsfor dependent care assistance or adoptionassistance. The uniform coverage rule ap-plies only to health FSAs and does not ap-ply to FSAs for dependent care assistanceor adoption assistance. See paragraphs (i)and (j) of this section for the rules for FSAsfor dependent care assistance and adoptionassistance.

2007–39 I.R.B. 702 September 24, 2007

(e) Required period of coverage fora health FSA, dependent care FSAand adoption assistance FSA—(1)Twelve-month period of coverage—ingeneral. An FSA’s period of coveragemust be 12 months. However, in the caseof a short plan year, the period of coverageis the entire short plan year. See paragraph(d) in §1.125–1 for rules on plan years andchanging plan years.

(2) COBRA elections for health FSAs.For the application of the health care con-tinuation rules of section 4980B of theCode to health FSAs, see Q & A–2 in§54.4980B–2 of this chapter.

(3) Separate period of coverage per-mitted for each qualified benefit offeredthrough FSA. Dependent care assistance,adoption assistance, and a health FSA areeach permitted to have a separate period ofcoverage, which may be different from theplan year of the cafeteria plan.

(f) Coverage on a month-by-month orexpense-by-expense basis prohibited. Inorder for reimbursements from an accidentand health plan to qualify for the section105(b) exclusion, an employer-funded ac-cident and health plan offered through acafeteria plan may not operate in a man-ner that enables employees to purchase theaccident and health plan coverage only forperiods when employees expect to incurmedical care expenses. Thus, for example,if a cafeteria plan permits employees to re-ceive accident and health plan coverage ona month-by-month or an expense-by-ex-pense basis, reimbursements from the ac-cident and health plan fail to qualify for thesection 105(b) exclusion. If, however, theperiod of coverage under an accident andhealth plan offered through a cafeteria planis twelve months and the cafeteria plandoes not permit an employee to elect spe-cific amounts of coverage, reimbursement,or salary reduction for less than twelvemonths, the cafeteria plan does not operateto enable participants to purchase coverageonly for periods during which medical carewill be incurred. See §1.125–4 and para-graph (a) in §1.125–2 regarding the revo-cation of elections during a period of cov-erage on account of changes in family sta-tus.

(g) FSA administrative practices—(1)Limiting health FSA enrollment to employ-ees who participate in the employer’s ac-cident and health plan. At the employer’soption, a cafeteria plan is permitted to pro-

vide that only those employees who partic-ipate in one or more specified employer-provided accident and health plans mayparticipate in a health FSA. See §1.125–7for nondiscrimination rules.

(2) Interval for employees’ salary re-duction contributions. The cafeteria planis permitted to specify any interval foremployees’ salary reduction contributions.The interval specified in the plan must beuniform for all participants.

(h) Qualified benefits permitted to beoffered through an FSA. Dependent careassistance (section 129), adoption assis-tance (section 137) and a medical reim-bursement arrangement (section 105(b))are permitted to be offered through anFSA in a cafeteria plan.

(i) Section 129 rules for dependent careassistance program offered through a cafe-teria plan—(1) General rule. In order fordependent care assistance to be a quali-fied benefit that is excludible from grossincome if elected through a cafeteria plan,the cafeteria plan must satisfy section 125and the dependent care assistance must sat-isfy section 129.

(2) Dependent care assistance in gen-eral. Section 129(a) provides an employeewith an exclusion from gross income bothfor an employer-funded dependent care as-sistance program and for amounts paid orincurred by the employer for dependentcare assistance provided to the employee,if the amounts are paid or incurred througha dependent care assistance program. Seeparagraph (a)(4) in §1.125–6 on when de-pendent care expenses are incurred.

(3) Reimbursement exclusively for de-pendent care assistance. A dependentcare assistance program may not providereimbursements other than for dependentcare expenses; in particular, if an em-ployee has dependent care expenses lessthan the amount specified by salary re-duction, the plan may not provide othertaxable or nontaxable benefits for any por-tion of the specified amount not used forthe reimbursement of dependent care ex-penses. Thus, if an employee has electedcoverage under the dependent care assis-tance program and the period of coveragehas commenced, the employee must nothave the right to receive amounts fromthe program other than as reimburse-ments for dependent care expenses. Thisis the case regardless of whether cover-age under the program is purchased with

contributions made at the employer’s dis-cretion, at the employee’s discretion, orpursuant to a collective bargaining agree-ment. Arrangements formally outside ofthe cafeteria plan providing for the ad-justment of an employee’s compensationor an employee’s receipt of any otherbenefits on the basis of the assistance orreimbursements received by the employeeare considered in determining whether adependent care benefit is a dependent careassistance program under section 129.

(j) Section 137 rules for adoption assis-tance program offered through a cafeteriaplan—(1) General rule. In order for adop-tion assistance to be a qualified benefit thatis excludible from gross income if electedthrough a cafeteria plan, the cafeteria planmust satisfy section 125 and the adoptionassistance must satisfy section 137.

(2) Adoption assistance in general.Section 137(a) provides an employeewith an exclusion from gross income foramounts paid or expenses incurred by theemployer for qualified adoption expensesin connection with an employee’s adop-tion of a child, if the amounts are paid orincurred through an adoption assistanceprogram. Certain limits on amount ofexpenses and employee’s income apply.

(3) Reimbursement exclusively foradoption assistance. Rules and require-ments similar to the rules and requirementsin paragraph (i)(3) of this section for de-pendent care assistance apply to adoptionassistance.

(k) FSAs and the rules governing thetax-favored treatment of employer-pro-vided health benefits—(1) Medical ex-penses. Health plans that are flexiblespending arrangements, as defined inparagraph (a)(1) of this section, mustconform to the generally applicable rulesunder sections 105 and 106 in order forthe coverage and reimbursements undersuch plans to qualify for tax-favored treat-ment under such sections. Thus, healthFSAs must qualify as accident and healthplans. See paragraph (n) in §1.125–1. Ahealth FSA is only permitted to reimbursemedical expenses as defined in section213(d). Thus, for example, a health FSAis not permitted to reimburse dependentcare expenses.

(2) Limiting payment or reimburse-ment to certain section 213(d) medicalexpenses. A health FSA is permitted tolimit payment or reimbursement to only

September 24, 2007 703 2007–39 I.R.B.

certain section 213(d) medical expenses(except health insurance, long-term careservices or insurance). See paragraph (q)in §1.125–1. For example, a health FSA ina cafeteria plan is permitted to provide inthe written plan that the plan reimburses allsection 213(d) medical expenses allowedto be paid or reimbursed under a cafeteriaplan except over-the-counter drugs.

(3) Application of prohibition againstdeferred compensation to medical ex-penses. (i) Certain advance payments fororthodontia permitted. A cafeteria plan ispermitted, but is not required to, reimburseemployees for orthodontia services beforethe services are provided but only to theextent that the employee has actually madethe payments in advance of the orthodon-tia services in order to receive the services.These orthodontia services are deemed tobe incurred when the employee makes theadvance payment. Reimbursing advancepayments does not violate the prohibitionagainst deferring compensation.

(ii) Example. The following exampleillustrates the rules in paragraph (k)(3):

Example. Advance payment to orthodontist.Employer D sponsors a calendar year cafeteriaplan which offers a health FSA. Employee K electsto salary reduce $3,000 for a health FSA for the2009 plan year. Employee K’s dependent requiresorthodontic treatment. K’s accident and health insur-ance does not cover orthodontia. The orthodontist,following the normal practice, charges $3,000, alldue in 2009, for treatment, to begin in 2009 and endin 2010. K pays the $3,000 in 2009. In 2009, Em-ployer D’s cafeteria plan may reimburse $3,000 toK, without violating the prohibition against deferringcompensation in section 125(d)(2).

(iii) Reimbursements for durable medi-cal equipment. A health FSA in a cafeteriaplan that reimburses employees for equip-ment (described in section 213(d)) with auseful life extending beyond the period ofcoverage during which the expense is in-curred does not provide deferred compen-sation. For example, a health FSA is per-mitted to reimburse the cost of a wheel-chair for an employee.

(4) No reimbursement of premiumsfor accident and health insurance orlong-term care insurance or services. Ahealth FSA is not permitted to treat em-ployees’ premium payments for otherhealth coverage as reimbursable expenses.Thus, for example, a health FSA is notpermitted to reimburse employees for pay-ments for other health plan coverage, in-cluding premiums for COBRA coverage,accidental death and dismemberment in-

surance, long-term disability or short-termdisability insurance or for health coverageunder a plan maintained by the employerof the employee or the employer of theemployee’s spouse or dependent. Also, ahealth FSA is not permitted to reimburseexpenses for long-term care insurancepremiums or for long-term care servicesfor the employee or employee’s spouse ordependent. See paragraph (q) in §1.125–1for nonqualified benefits.

(l) Section 105(h) requirements. Sec-tion 105(h) applies to health FSAs. Sec-tion 105(h) provides that the exclusionprovided by section 105(b) is not availablewith respect to certain amounts receivedby a highly compensated individual (asdefined in section 105(h)(5)) from a dis-criminatory self-insured medical reim-bursement plan, which includes healthFSAs. See §1.105–11. For purposes ofsection 105(h), coverage by a self-insuredaccident and health plan offered through acafeteria plan is an optional benefit (evenif only one level and type of coverageis offered) and, for purposes of the op-tional benefit rule in §1.105–11(c)(3)(i),employer contributions are treated as em-ployee contributions to the extent thattaxable benefits are offered by the plan.

(m) HSA-compatible FSAs-limited-pur-pose health FSAs and post-deductiblehealth FSAs—(1) In general. Limited-pur-pose health FSAs and post-deductiblehealth FSAs which satisfy all the require-ments of section 125 are permitted to beoffered through a cafeteria plan.

(2) HSA-compatible FSAs. Section223(a) allows a deduction for certain con-tributions to a “Health Savings Account”(HSA) (as defined in section 223(d)). Aneligible individual (as defined in section223(c)(1)) may contribute to an HSA. Aneligible individual must be covered undera “high deductible health plan” (HDHP)and not, while covered under an HDHP,under any health plan which is not anHDHP. A general purpose health FSA isnot an HDHP and an individual coveredby a general purpose health FSA is not el-igible to contribute to an HSA. However,an individual covered by an HDHP (andwho otherwise satisfies section 223(c)(1))does not fail to be an eligible individualmerely because the individual is also cov-ered by a limited-purpose health FSA orpost-deductible health FSA (as defined inthis paragraph (m)) or a combination of a

limited-purpose health FSA and a post-de-ductible health FSA.

(3) Limited-purpose health FSA. Alimited-purpose health FSA is a healthFSA described in the cafeteria plan thatonly pays or reimburses permitted cov-erage benefits (as defined in section223(c)(2)(C)), such as vision care, dentalcare or preventive care (as defined forpurposes of section 223(c)(2)(C)). Seeparagraph (k) in this section.

(4) Post-deductible health FSA—(i) Ingeneral. A post-deductible health FSA is ahealth FSA described in the cafeteria planthat only pays or reimburses medical ex-penses (as defined in section 213(d)) forpreventive care or medical expenses in-curred after the minimum annual HDHPdeductible under section 223(c)(2)(A)(i) issatisfied. See paragraph (k) in this sec-tion. No medical expenses incurred be-fore the annual HDHP deductible is sat-isfied may be reimbursed by a post-de-ductible FSA, regardless of whether theHDHP covers the expense or whether thedeductible is later satisfied. For example,even if chiropractic care is not covered un-der the HDHP, expenses for chiropracticcare incurred before the HDHP deductibleis satisfied are not reimbursable at any timeby a post-deductible health FSA.

(ii) HDHP and health FSA deductibles.The deductible for a post-deductible healthFSA need not be the same amount as thedeductible for the HDHP, but in no eventmay the post-deductible health FSA orother coverage provide benefits beforethe minimum annual HDHP deductibleunder section 223(c)(2)(A)(i) is satisfied(other than benefits permitted under alimited-purpose health FSA). In addition,although the deductibles of the HDHPand the other coverage may be satisfiedindependently by separate expenses, nobenefits may be paid before the mini-mum annual deductible under section223(c)(2)(A)(i) has been satisfied. Anindividual covered by a post-deductiblehealth FSA (if otherwise an eligible in-dividual) is an eligible individual for thepurpose of contributing to the HSA.

(5) Combination of limited-purposehealth FSA and post-deductible healthFSA. An FSA is a combination of a lim-ited-purpose health FSA and post-de-ductible health FSA if each of the bene-fits and reimbursements provided underthe FSA are permitted under either a

2007–39 I.R.B. 704 September 24, 2007

limited-purpose health FSA or post-de-ductible health FSA. For example, be-fore the HDHP deductible is satisfied, acombination limited-purpose and post-de-ductible health FSA may reimburse onlypreventive, vision or dental expenses. Acombination limited-purpose and post-de-ductible health FSA may also reimburseany medical expense that may otherwisebe paid by an FSA (that is, no insurancepremiums or long-term care benefits) thatis incurred after the HDHP deductible issatisfied.

(6) Substantiation. The substantiationrules in this section apply to limited-pur-pose health FSAs and to post-deductiblehealth FSAs. In addition to providingthird-party substantiation of medical ex-penses, a participant in a post-deductiblehealth FSA must provide information froman independent third party that the HDHPdeductible has been satisfied. A partici-pant in a limited-purpose health FSA mustprovide information from an independentthird-party that the medical expenses arefor vision care, dental care or preventivecare.

(7) Plan amendments. See paragraph(c) in §1.125–1 on the required effectivedate for amendments adopting or chang-ing limited-purpose, post-deductible orcombination limited-purpose and post-de-ductible health FSAs.

(n) Qualified HSA distributions—(1)In general. A health FSA in a cafeteriaplan is permitted to offer employees theright to elect qualified HSA distributionsdescribed in section 106(e). No quali-fied HSA distribution may be made in aplan year unless the employer amends thehealth FSA written plan with respect toall employees, effective by the last day ofthe plan year, to allow a qualified HSAdistribution satisfying all the requirementsin this paragraph (n). See also section106(e)(5)(B). In addition, a distributionwith respect to an employee is not a qual-ified HSA distribution unless all of thefollowing the requirements are satisfied—

(i) No qualified HSA distribution hasbeen previously made on behalf of the em-ployee from this health FSA;

(ii) The employee elects to have the em-ployer make a qualified HSA distributionfrom the health FSA to the HSA of the em-ployee;

(iii) The distribution does not exceedthe lesser of the balance of the health FSAon—

(A) September 21, 2006; or(B) The date of the distribution;(iv) For purposes of this paragraph

(n)(1), balances as of any date are de-termined on a cash basis, without takinginto account expenses incurred but notreimbursed as of a date, and applying theuniform coverage rule in paragraph (d) inthis section;

(v) The distribution is made no laterthan December 31, 2011; and

(vi) The employer makes the distri-bution directly to the trustee of the em-ployee’s HSA.

(2) Taxation of qualified HSA distribu-tions. A qualified HSA distribution fromthe health FSA covering the participantto his or her HSA is a rollover to theHSA (as defined in section 223(f)(5)) andthus is generally not includible in gross in-come. However, if the participant is notan eligible individual (as defined in section223(c)(1)) at any time during a testing pe-riod following the qualified HSA distribu-tion, the amount of the distribution is in-cludible in the participant’s gross incomeand he or she is also subject to an addi-tional 10 percent tax (with certain excep-tions). Section 106(e)(3).

(3) No effect on health FSA elections,coverage, use-or-lose rule. A qualifiedHSA distribution does not alter an em-ployee’s irrevocable election under para-graph (a) of §1.125–2, or constitute achange in status under §1.125–4(a). If aqualified HSA distribution is made to anemployee’s HSA, even if the balance ina health FSA is reduced to zero, the em-ployee’s health FSA coverage continues tothe end of the plan year. Unused benefitsand contributions remaining at the end ofa plan year (or at the end of a grace period,if applicable) must be forfeited.

(o) FSA experience gains or forfei-tures—(1) Experience gains in general.An FSA experience gain (sometimes re-ferred to as forfeitures in the use-or-loserule in paragraph (c) in this section) withrespect to a plan year (plus any graceperiod following the end of a plan yeardescribed in paragraph (e) in §1.125–1),equals the amount of the employer con-tributions, including salary reduction con-tributions, and after-tax employee contri-butions to the FSA minus the FSA’s total

claims reimbursements for the year. Ex-perience gains (or forfeitures) may be—

(i) Retained by the employer maintain-ing the cafeteria plan; or

(ii) If not retained by the employer, maybe used only in one or more of the follow-ing ways—

(A) To reduce required salary reduc-tion amounts for the immediately follow-ing plan year, on a reasonable and uniformbasis, as described in paragraph (o)(2) ofthis section;

(B) Returned to the employees on a rea-sonable and uniform basis, as described inparagraph (o)(2) of this section; or

(C) To defray expenses to administerthe cafeteria plan.

(2) Allocating experience gains amongemployees on reasonable and uniform ba-sis. If not retained by the employer orused to defray expenses of administeringthe plan, the experience gains must be al-located among employees on a reasonableand uniform basis. It is permissible to al-locate these amounts based on the differ-ent coverage levels of employees under theFSA. Experience gains allocated in com-pliance with this paragraph (o) are not adeferral of the receipt of compensation.However, in no case may the experiencegains be allocated among employees based(directly or indirectly) on their individualclaims experience. Experience gains maynot be used as contributions directly or in-directly to any deferred compensation ben-efit plan.

(3) Example. The following exampleillustrates the rules in this paragraph (o):

Example. Allocating experience gains. (i) Em-ployer L maintains a cafeteria plan for its 1,200 em-ployees, who may elect one of several different an-nual coverage levels under a health FSA in $100 in-crements from $500 to $2,000.

(ii) For the 2009 plan year, 1,000 employees electlevels of coverage under the health FSA. For the 2009plan year, the health FSA has an experience gain of$5,000.

(iii) The $5,000 may be allocated to all partici-pants for the plan year on a per capita basis weightedto reflect the participants’ elected levels of coverage.

(iv) Alternatively, the $5,000 may be used to re-duce the required salary reduction amount under thehealth FSA for all 2009 participants (for example, a$500 health FSA for the next year is priced at $480) orto reimburse claims incurred above the elective limitin 2010 as long as such reimbursements are made ona reasonable and uniform level.

(p) Effective/applicability date. It isproposed that these regulations apply onand after plan years beginning on or afterJanuary 1, 2009.

September 24, 2007 705 2007–39 I.R.B.

§1.125–6 Substantiation of expenses forall cafeteria plans.

(a) Cafeteria plan payments and reim-bursements—(1) In general. A cafeteriaplan may pay or reimburse only those sub-stantiated expenses for qualified benefitsincurred on or after the later of the effec-tive date of the cafeteria plan and the datethe employee is enrolled in the plan. Thisrequirement applies to all qualified bene-fits offered through the cafeteria plan. Seeparagraph (b) of this section for substanti-ation rules.

(2) Expenses incurred. (i) Employees’medical expenses must be incurred duringthe period of coverage. In order for re-imbursements to be excludible from grossincome under section 105(b), the medicalexpenses reimbursed by an accident andhealth plan elected through a cafeteria planmust be incurred during the period whenthe participant is covered by the accidentand health plan. A participant’s period ofcoverage includes COBRA coverage. See§54.4980B–2 of this chapter. Medical ex-penses incurred before the later of the ef-fective date of the plan and the date the em-ployee is enrolled in the plan are not in-curred during the period for which the em-ployee is covered by the plan. However,the actual reimbursement of covered med-ical care expenses may be made after theapplicable period of coverage.

(ii) When medical expenses are in-curred. For purposes of this rule, medicalexpenses are incurred when the employee(or the employee’s spouse or dependents)is provided with the medical care thatgives rise to the medical expenses, andnot when the employee is formally billed,charged for, or pays for the medical care.

(iii) Example. The following exampleillustrates the rules in this paragraph (a)(2):

Example. Medical expenses incurred after ter-mination. (i) Employer E maintains a cafeteria planwith a calendar year plan year. The cafeteria planprovides that participation terminates when an indi-vidual ceases to be an employee of Employer E, un-less the former employee elects to continue to par-ticipate in the health FSA under the COBRA rulesin §54.4980B–2 of this chapter. Employee G timelyelects to salary reduce $1,200 to participate in a healthFSA for the 2009 plan year. As of June 30, 2009,Employee G has contributed $600 toward the healthFSA, but incurred no medical expenses. On June 30,2009, Employee G terminates employment and doesnot continue participation under COBRA. On July 15,2009, G incurs a section 213(d) medical expense of$500.

(ii) Under the rules in paragraph (a)(2) of this sec-tion, the cafeteria plan is prohibited from reimbursingany portion of the $500 medical expense because, atthe time the medical expense is incurred, G is not aparticipant in the cafeteria plan.

(3) Section 105(b) requirements for re-imbursement of medical expenses througha cafeteria plan. (i) In general. In orderfor medical care reimbursements paid toan employee through a cafeteria plan tobe excludible under section 105(b), thereimbursements must be paid pursuant toan employer-funded accident and healthplan, as defined in section 105(e) and§§1.105–2 and 1.105–5.

(ii) Reimbursement exclusively for sec-tion 213(d) medical expenses. A cafeteriaplan benefit through which an employeereceives reimbursements of medical ex-penses is excludable under section 105(b)only if reimbursements from the plan aremade specifically to reimburse the em-ployee for medical expenses (as defined insection 213(d)) incurred by the employeeor the employee’s spouse or dependentsduring the period of coverage. Amountspaid to an employee as reimbursement arenot paid specifically to reimburse the em-ployee for medical expenses if the planprovides that the employee is entitled, oroperates in a manner that entitles the em-ployee, to receive the amounts, in the formof cash (for example, routine payment ofsalary) or any other taxable or nontax-able benefit irrespective of whether theemployee (or the employee’s spouse or de-pendents) incurs medical expenses duringthe period of coverage. This rule applieseven if the employee will not receive suchamounts until the end or after the end ofthe period. A plan under which employees(or their spouses and dependents) will re-ceive reimbursement for medical expensesup to a specified amount and, if they incurno medical expenses, will receive cash orany other benefit in lieu of the reimburse-ments is not a benefit qualifying for the ex-clusion under sections 106 and 105(b). See§1.105–2. This is the case without regardto whether the benefit was purchased withcontributions made at the employer’s dis-cretion, at the employee’s discretion (forexample, by salary reduction election), orpursuant to a collective bargaining agree-ment.

(iii) Other arrangements. Arrange-ments formally outside of the cafeteriaplan that adjust an employee’s compen-

sation or an employee’s receipt of anyother benefits on the basis of the expensesincurred or reimbursements the employeereceives are considered in determiningwhether the reimbursements are througha plan eligible for the exclusions undersections 106 and 105(b).

(4) Reimbursements of dependent careexpenses. (i) Dependent care expensesmust be incurred. In order to satisfy sec-tion 129, dependent care expenses may notbe reimbursed before the expenses are in-curred. For purposes of this rule, depen-dent care expenses are incurred when thecare is provided and not when the em-ployee is formally billed, charged for, orpays for the dependent care.

(ii) Dependent care provided during theperiod of coverage. In order for depen-dent care assistance to be provided througha dependent care assistance program eligi-ble for the section 129 exclusion, the caremust be provided to or on behalf of theemployee during the period for which theemployee is covered by the program. Forexample, if for a plan year, an employeeelects a dependent care assistance programproviding for reimbursement of dependentcare expenses, only reimbursements fordependent care expenses incurred duringthat plan year are provided from a depen-dent care assistance program within thescope of section 129. Also, for purposes ofthis rule, expenses incurred before the laterof the program’s effective date and the datethe employee is enrolled in the programare not incurred during the period when theemployee is covered by the program. Sim-ilarly, if the dependent care assistance pro-gram furnishes the dependent care in-kind(for example, through an employer-main-tained child care facility), only dependentcare provided during the plan year of cov-erage is provided through a dependent careassistance program within the meaning ofsection 129. See also §1.125–5 for FSArules.

(iii) Period of coverage. In order for de-pendent care assistance through a cafete-ria plan to be provided through a depen-dent care assistance program eligible forthe section 129 exclusion, the plan may notoperate in a manner that enables employ-ees to purchase dependent care assistanceonly for periods during which the employ-ees expect to receive dependent care as-sistance. If the period of coverage for adependent care assistance program offered

2007–39 I.R.B. 706 September 24, 2007

through a cafeteria plan is twelve months(or, in the case of a short plan year, at leastequal to the short plan year) and the plandoes not permit an employee to elect spe-cific amounts of coverage, reimbursement,or salary reduction for less than twelvemonths, the plan is deemed not to operateto enable employees to purchase coverageonly for periods when dependent care as-sistance will be received. See paragraph(a) in §1.125–2 and §1.125–4 regardingthe revocation of elections during the pe-riod of coverage on account of changes infamily status. See paragraph (e) in this sec-tion for required period of coverage for de-pendent care assistance.

(iv) Examples. The following examplesillustrate the rules in paragraphs (a)(4)(i)-(iii) of this section:

Example 1. Initial non-refundable fee for childcare. (i) Employer F maintains a calendar year cafete-ria plan, offering employees an election between cashand qualified benefits, including dependent care as-sistance. Employee M has a one-year old dependentchild. Employee M timely elected $5,000 of depen-dent care assistance for 2009. During the entire 2009plan year, Employee M satisfies all the requirementsin section 129 for dependent care assistance.

(ii) On February 1, 2009, Employee M pays aninitial non-refundable fee of $500 to a licensed childcare center (unrelated to Employer F or to EmployeeM), to reserve a space at the child care center for M’schild. The child care center’s monthly charges forchild care are $1,200. When the child care center firstbegins to care for M’s child, the $500 non-refundablefee is applied toward the first month’s charges forchild care.

(iii) On March 1, 2009, the child care center be-gins caring for Employee M’s child, and continuesto care for the child through December 31, 2009. OnMarch 1, 2009, M pays the child care center $700 (thebalance of the $1,200 in charges for child care to beprovided in March 2009). On April 1, 2009, M paysthe child care center $1,200 for the child care to beprovided in April 2009.

(iv) Dependent care expenses are incurred whenthe services are provided. For dependent care ser-vices provided in March 2009, the $500 nonrefund-able fee paid on February 1, 2009, and the $700 paidon March 1, 2009 may be reimbursed on or after thelater of the date when substantiated or April 1, 2009.For dependent care services provided in April 2009,the $1,200 paid on April 1, 2009 may be reimbursedon or after the later of the date when substantiated orMay 1, 2009.

Example 2. Non-refundable fee forfeited. Samefacts as Example 1, except that the child care centernever cared for M’s child (who was instead cared forat Employer F’s onsite child care facility). Becausethe child care center never provided child care ser-vices to Employee M’s child, the $500 non-refund-able fee is not reimbursable.

(v) Optional spend-down provision. Atthe employer’s option, the written cafete-ria plan may provide that dependent care

expenses incurred after the date an em-ployee ceases participation in the cafeteriaplan (for example, after termination) andthrough the last day of that plan year (orgrace period immediately after that planyear) may be reimbursed from unused ben-efits, if all of the requirements of section129 are satisfied.

(vi) Example. The following exampleillustrates the rules in paragraph (a)(4)(v)of this section:

Example. Terminated employee’s post-termina-tion dependent care expenses. (i) For calendar year2009, Employee X elects $5,000 salary reductionfor dependent care assistance through EmployerG’s cafeteria plan. X works for Employer G fromJanuary 1 through June 30, 2009, when X termi-nates employment. As of June 30, 2009, X had paid$2,500 in salary reduction and had incurred and wasreimbursed for $2,000 of dependent care expenses.

(ii) X does not work again until October 1, 2009,when X begins work for Employer H. X was em-ployed by Employer H from October 1, 2009 throughDecember 31, 2009. During this period, X also in-curred $500 of dependent care expenses. During allthe periods of employment in 2009, X satisfied all re-quirements in section 129 for excluding payments fordependent care assistance from gross income.

(iii) Employer G’s cafeteria plan allows termi-nated employees to “spend down” unused salary re-duction amounts for dependent care assistance, if allrequirements of section 129 are satisfied. After X’sclaim for $500 of dependent care expenses is sub-stantiated, Employer G’s cafeteria plan reimburses Xfor $500 (the remaining balance) of dependent careexpenses incurred during X’s employment for Em-ployer H between October 1, 2009 and December 31,2009. Employer G’s cafeteria plan and operation areconsistent with section 125.

(b) Rules for claims substantiation forcafeteria plans—(1) Substantiation re-quired before reimbursing expenses forqualified benefits. This paragraph (b) setsforth the substantiation requirements thata cafeteria plan must satisfy before payingor reimbursing any expense for a qualifiedbenefit.

(2) All claims must be substantiated. Asa precondition of payment or reimburse-ment of expenses for qualified benefits, acafeteria plan must require substantiationin accordance with this section. Substanti-ating only a percentage of claims, or sub-stantiating only claims above a certain dol-lar amount, fails to comply with the sub-stantiation requirements in §1.125–1 andthis section.

(3) Substantiation by independentthird-party. (i) In general. All expensesmust be substantiated by information froma third-party that is independent of theemployee and the employee’s spouse and

dependents. The independent third-partymust provide information describing theservice or product, the date of the serviceor sale, and the amount. Self-substanti-ation or self-certification of an expenseby an employee does not satisfy the sub-stantiation requirements of this paragraph(b). The specific requirements in sections105(b), 129, and 137 must also be satisfiedas a condition of reimbursing expenses forqualified benefits. For example, a healthFSA does not satisfy the requirements ofsection 105(b) if it reimburses employeesfor expenses where the employees onlysubmit information describing medical ex-penses, the amount of the expenses and thedate of the expenses but fail to provide astatement from an independent third-party(either automatically or subsequent to thetransaction) verifying the expenses. Un-der §1.105–2, all amounts paid under aplan that permits self-substantiation orself-certification are includible in grossincome, including amounts reimbursedfor medical expenses, whether or not sub-stantiated. See paragraph (m) in §1.125–5for additional substantiation rules for lim-ited-purpose and post-deductible healthFSAs.

(ii) Rules for substantiation of healthFSA claims using an explanation of ben-efits provided by an insurance company.(A) Written statement from an indepen-dent third-party. If the employer is pro-vided with information from an indepen-dent third-party (such as an “explanationof benefits” (EOB) from an insurance com-pany) indicating the date of the section213(d) medical care and the employee’sresponsibility for payment for that medi-cal care (that is, coinsurance payments andamounts below the plan’s deductible), andthe employee certifies that any expensepaid through the health FSA has not beenreimbursed and that the employee will notseek reimbursement from any other plancovering health benefits, the claim is fullysubstantiated without the need for submis-sion of a receipt by the employee or furtherreview.

(B) Example. The following exam-ple illustrates the rules in this paragraph(b)(3):

Example. Explanation of benefits. (i) During theplan year ending December 31, 2009, Employee Qis a participant in the health FSA sponsored by Em-ployer J and is enrolled in Employer J’s accident andhealth plan.

September 24, 2007 707 2007–39 I.R.B.

(ii) On March 1, 2009, Q visits a physician’s of-fice for medical care as defined in section 213(d). Thecharge for the physician’s services is $150. Under theplan, Q is responsible for 20 percent of the charge forthe physician’s services (that is, $30). Q has suffi-cient FSA coverage for the $30 claim.

(iii) Employer J has coordinated with the accidentand health plan so that Employer J or its agent au-tomatically receives an EOB from the plan indicat-ing that Q is responsible for payment of 20 percentof the $150 charged by the physician. Because Em-ployer J has received a statement from an independentthird-party that Q has incurred a medical expense, thedate the expense was incurred, and the amount of theexpense, the claim is substantiated without the needfor J to submit additional information regarding theexpense. Employer J’s FSA reimburses Q the $30medical expense without requiring Q to submit a re-ceipt or a statement from the physician. The substan-tiation rules in paragraph (b) in this section are satis-fied.

(4) Advance reimbursement of expensesfor qualified benefits prohibited. Reim-bursing expenses before the expense hasbeen incurred or before the expense is sub-stantiated fails to satisfy the substantiationrequirements in §1.105–2, §1.125–1 andthis section.

(5) Purported loan from employer toemployee. In determining whether, un-der all the facts and circumstances, em-ployees are being reimbursed for unsub-stantiated claims, special scrutiny will begiven to other arrangements such as em-ployer-to-employee loans based on actualor projected employee claims.

(6) Debit cards. For purposes of thissection, a debit card is a debit card, creditcard, or stored value card. See also para-graphs (c) through (g) of this section foradditional rules on payments or reimburse-ments made through debit cards.

(c) Debit cards-overview—(1) Manda-tory rules for all debit cards usable to payor reimburse medical expenses. Paragraph(d) of this section sets forth the mandatoryprocedures for debit cards to substantiatesection 213(d) medical expenses. Theserules apply to all debit cards used to payor reimburse medical expenses. Paragraph(e) of this section sets forth additionalsubstantiation rules that may be used formedical expenses incurred at medical careproviders and certain stores with the DrugStores and Pharmacies merchant categorycode. Paragraph (f) in this section setsforth the requirements for an inventoryinformation approval system which mustbe used to substantiate medical expensesincurred at merchants or service providersthat are not medical care providers or

certain stores with the Drug Stores andPharmacies merchant category code andthat may be used for medical expensesincurred at all merchants.

(2) Debit cards used for dependent careassistance. Paragraph (g) of this sectionsets forth additional rules for debit cardsusable for reimbursing dependent care ex-penses.

(3) Additional guidance. The Com-missioner may prescribe additional guid-ance of general applicability, publishedin the Internal Revenue Bulletin (see§601.601(d)(2)(ii)(b) of this chapter), toprovide additional rules for debit cards.

(d) Mandatory rules for all debit cardsusable to pay or reimburse medical ex-penses. A health FSA paying or reim-bursing section 213(d) medical expensesthrough a debit card must satisfy all of thefollowing requirements—

(1) Before any employee participatingin a health FSA receives the debit card, theemployee agrees in writing that he or shewill only use the card to pay for medicalexpenses (as defined in section 213(d)) ofthe employee or his or her spouse or depen-dents, that he or she will not use the debitcard for any medical expense that has al-ready been reimbursed, that he or she willnot seek reimbursement under any otherhealth plan for any expense paid for witha debit card, and that he or she will ac-quire and retain sufficient documentation(including invoices and receipts) for anyexpense paid with the debit card.

(2) The debit card includes a statementproviding that the agreements described inparagraph (d)(1) of this section are reaf-firmed each time the employee uses thecard.

(3) The amount available through thedebit card equals the amount elected by theemployee for the health FSA for the cafe-teria plan year, and is reduced by amountspaid or reimbursed for section 213(d) med-ical expenses incurred during the plan year.

(4) The debit card is automatically can-celled when the employee ceases to partic-ipate in the health FSA.

(5) The employer limits use of the debitcard to—

(i) Physicians, dentists, vision careoffices, hospitals, other medical careproviders (as identified by the merchantcategory code);

(ii) Stores with the merchant categorycode for Drugstores and Pharmacies if, on

a location by location basis, 90 percent ofthe store’s gross receipts during the priortaxable year consisted of items which qual-ify as expenses for medical care describedin section 213(d); and

(iii) Stores that have implemented theinventory information approval system un-der paragraph (f).

(6) The employer substantiates claimsbased on payments to medical careproviders and stores described in para-graphs (d)(5)(i) and (ii) of this section inaccordance with either paragraph (e) orparagraph (f) of this section.

(7) The employer follows all of the fol-lowing correction procedures for any im-proper payments using the debit card—

(i) Until the amount of the improperpayment is recovered, the debit card mustbe de-activated and the employee mustrequest payments or reimbursements ofmedical expenses from the health FSAthrough other methods (for example, bysubmitting receipts or invoices from amerchant or service provider showing theemployee incurred a section 213(d) medi-cal expense);

(ii) The employer demands that the em-ployee repay the cafeteria plan an amountequal to the improper payment;

(iii) If, after the demand for repaymentof improper payment (as described in para-graph (d)(7)(ii) of this section), the em-ployee fails to repay the amount of the im-proper charge, the employer withholds theamount of the improper charge from theemployee’s pay or other compensation, tothe full extent allowed by applicable law;

(iv) If any portion of the improper pay-ment remains outstanding after attempts torecover the amount (as described in para-graph (d)(7)(ii) and (iii) of this section),the employer applies a claims substitutionor offset to resolve improper payments,such as a reimbursement for a later sub-stantiated expense claim is reduced by theamount of the improper payment. So,for example, if an employee has receivedan improper payment of $200 and subse-quently submits a substantiated claim for$250 incurred during the same coverageperiod, a reimbursement for $50 is made;and

(v) If, after applying all the proceduresdescribed in paragraph (d)(7)(ii) through(iv) of this section, the employee remainsindebted to the employer for improper pay-ments, the employer, consistent with its

2007–39 I.R.B. 708 September 24, 2007

business practice, treats the improper pay-ment as it would any other business indebt-edness.

(e) Substantiation of expenses incurredat medical care providers and certainother stores with Drug Stores and Phar-macies merchant category code—(1) Ingeneral. A health FSA paying or reim-bursing section 213(d) medical expensesthrough a debit card is permitted to com-ply with the substantiation provisions ofthis paragraph (e), instead of complyingwith the provisions of paragraph (f), formedical expenses incurred at providers de-scribed in paragraph (e)(2) of this section.

(2) Medical care providers and certainother stores with Drug Stores and Phar-macies merchant category code. Medicalexpenses may be substantiated using themethods described in paragraph (e)(3) ofthis section if incurred at physicians, phar-macies, dentists, vision care offices, hospi-tals, other medical care providers (as iden-tified by the merchant category code) andat stores with the Drug Stores and Pharma-cies merchant category code, if, on a storelocation-by-location basis, 90 percent ofthe store’s gross receipts during the priortaxable year consisted of items which qual-ify as expenses for medical care describedin section 213(d).

(3) Claims substantiation for copay-ment matches, certain recurring medicalexpenses and real-time substantiation.If all of the requirements in this para-graph (e)(3) are satisfied, copaymentmatches, certain recurring medical ex-penses and medical expenses substantiatedin real-time are substantiated without theneed for submission of receipts or furtherreview.

(i) Matching copayments—multiples offive or fewer. If an employer’s accidentor health plan covering the employee (orthe employee’s spouse or dependents) hascopayments in specific dollar amounts,and the dollar amount of the transactionat a medical care provider equals an ex-act multiple of not more than five timesthe dollar amount of the copayment forthe specific service (for example, phar-macy benefit copayment, copayment fora physician’s office visit) under the acci-dent or health plan covering the specificemployee-cardholder, then the charge isfully substantiated without the need forsubmission of a receipt or further review.

(A) Tiered copayments. If a health planhas multiple copayments for the same ben-efit, (for example, tiered copayments for apharmacy benefit), exact matches of mul-tiples or combinations of up to five co-payments are similarly fully substantiatedwithout the need for submission of a re-ceipt or further review.

(B) Copayment match must be exactmultiple. If the dollar amount of the trans-action is not an exact multiple of the co-payment (or an exact match of a multipleor combination of different copayments fora benefit in the case of multiple copay-ments), the transaction must be treated asconditional pending confirmation of thecharge, even if the amount is less than fivetimes the copayment.

(C) No match for multiple of six or moretimes copayment. If the dollar amount ofthe transaction at a medical care providerequals a multiple of six or more times thedollar amount of the copayment for thespecific service, the transaction must betreated as conditional pending confirma-tion of the charge by the submission of ad-ditional third-party information. See para-graph (d) of this section. In the case ofa plan with multiple copayments for thesame benefit, if the dollar amount of thetransaction exceeds five times the maxi-mum copayment for the benefit, the trans-action must also be treated as conditionalpending confirmation of the charge by thesubmission of additional third-party infor-mation. In these cases, the employer mustrequire that additional third-party informa-tion, such as merchant or service providerreceipts, be submitted for review and sub-stantiation, and the third-party informationmust satisfy the requirements in paragraph(b)(3) of this section.

(D) Independent verification of copay-ment required. The copayment schedulerequired under the accident or healthplan must be independently verified bythe employer. Statements or other rep-resentations by the employee are notsufficient. Self-substantiation or self-cer-tification of an employee’s copayment inconnection with copayment matching pro-cedures through debit cards or otherwisedoes not constitute substantiation. If aplan’s copayment matching system relieson an employee to provide a copaymentamount without verification of the amount,claims have not been substantiated, and allamounts paid from the plan are included in

gross income, including amounts paid formedical care whether or not substantiated.See paragraph (b) in this section.

(4) Certain recurring medical expenses.Automatic payment or reimbursementsatisfies the substantiation rules in thisparagraph (e) for payment of recurringexpenses that match expenses previouslyapproved as to amount, medical careprovider and time period (for example,for an employee who refills a prescrip-tion drug on a regular basis at the sameprovider and in the same amount). Thepayment is substantiated without the needfor submission of a receipt or further re-view.

(5) Real-time substantiation. If a thirdparty that is independent of the employeeand the employee’s spouse and dependents(for example, medical care provider, mer-chant, or pharmacy benefit manager) pro-vides, at the time and point of sale, infor-mation to verify to the employer (includ-ing electronically by email, the internet, in-tranet or telephone) that the charge is fora section 213(d) medical expense, the ex-pense is substantiated without the need forfurther review.

(6) Substantiation requirements forall other medical expenses paid or reim-bursed through a health FSA debit card.All other charges to the debit card (otherthan substantiated copayments, recurringmedical expenses or real-time substantia-tion, or charges substantiated through theinventory information approval systemdescribed in paragraph (f) of this section)must be treated as conditional, pendingsubstantiation of the charge through addi-tional independent third-party informationdescribing the goods or services, the dateof the service or sale and the amount of thetransaction. All such debit card paymentsmust be substantiated, regardless of theamount of the payment.

(f) Inventory information approvalsystem—(1) In general. An inventory in-formation approval system that complieswith this paragraph (f) may be used tosubstantiate payments made using a debitcard, including payments at merchants andservice providers that are not described inparagraph (e)(2) of this section. Debitcard transactions using this system arefully substantiated without the need forsubmission of a receipt by the employeeor further review.

September 24, 2007 709 2007–39 I.R.B.

(2) Operation of inventory informationapproval system. An inventory informa-tion approval system must operate in themanner described in this paragraph (f)(2).

(i) When an employee uses the card,the payment card processor’s or participat-ing merchant’s system collects informa-tion about the items purchased using theinventory control information (for exam-ple, stock keeping units (SKUs)). The sys-tem compares the inventory control infor-mation for the items purchased against alist of items, the purchase of which qual-ifies as expenses for medical care undersection 213(d) (including nonprescriptionmedications).

(ii) The section 213(d) medical ex-penses are totaled and the merchant’sor payment card processor’s system ap-proves the use of the card only for theamount of the section 213(d) medicalexpenses eligible for coverage under thehealth FSA (taking into consideration theuniform coverage rule in paragraph (d) of§1.125–5);

(iii) If the transaction is only partiallyapproved, the employee is required to ten-der additional amounts, resulting in a split-tender transaction. For example, if, aftermatching inventory information, it is de-termined that all items purchased are sec-tion 213(d) medical expenses, the entiretransaction is approved, subject to the cov-erage limitations of the health FSA;

(iv) If, after matching inventory infor-mation, it is determined that only someof the items purchased are section 213(d)medical expenses, the transaction is ap-proved only as to the section 213(d) medi-cal expenses. In this case, the merchant orservice-provider must request additionalpayment from the employee for the itemsthat do not satisfy the definition of medicalcare under section 213(d);

(v) The merchant or service-providermust also request additional paymentfrom the employee if the employee doesnot have sufficient health FSA coverage topurchase the section 213(d) medical items;

(vi) Any attempt to use the cardat non-participating merchants or ser-vice-providers must fail.

(3) Employer’s responsibility for en-suring inventory information approvalsystem’s compliance with §1.105–2,§1.125–1, §1.125–6 and recordkeepingrequirements. An employer that uses theinventory information approval system

must ensure that the inventory infor-mation approval system complies withthe requirements in §§1.105–2, 1.125–1,and §1.125–6 for substantiating, payingor reimbursing section 213(d) medicalexpenses and with the recordkeeping re-quirements in section 6001.

(g) Debit cards used to pay or reim-burse dependent care assistance—(1) Ingeneral. An employer may use a debitcard to provide benefits under its depen-dent care assistance program (including adependent care assistance FSA). However,dependent care expenses may not be reim-bursed before the expenses are incurred.See paragraph (a)(4) in this section. Thus,if a dependent care provider requires pay-ment before the dependent care servicesare provided, the expenses cannot be reim-bursed at the time of payment through useof a debit card or otherwise.

(2) Reimbursing dependent care assis-tance through a debit card. An employeroffering a dependent care assistance FSAmay adopt the following method to pro-vide reimbursements for dependent careexpenses through a debit card—

(i) At the beginning of the plan yearor upon enrollment in the dependent careassistance program, the employee paysinitial expenses to the dependent careprovider and substantiates the initial ex-penses by submitting to the employer orplan administrator a statement from thedependent care provider substantiating thedates and amounts for the services pro-vided.

(ii) After the employer or plan admin-istrator receives the substantiation (but notbefore the date the services are provided asindicated by the statement provided by thedependent care provider), the plan makesavailable through the debit card an amountequal to the lesser of—

(A) The previously incurred and sub-stantiated expense; or

(B) The employee’s total salary reduc-tion amount to date.

(iii) The card may be used to pay forsubsequently incurred dependent care ex-penses.

(iv) The amount available through thecard may be increased in the amount of anyadditional dependent care expenses onlyafter the additional expenses have been in-curred.

(3) Substantiating recurring dependentcare expenses. Card transactions that col-

lect information matching expenses pre-viously substantiated and approved as todependent care provider and time periodmay be treated as substantiated withoutfurther review if the transaction is for anamount equal to or less than the previouslysubstantiated expenses. Similarly, depen-dent care expenses previously substanti-ated and approved through nonelectronicmethods may also be treated as substanti-ated without further review. In both cases,if there is an increase in previously sub-stantiated amounts or a change in the de-pendent care provider, the employee mustsubmit a statement or receipt from the de-pendent care provider substantiating theclaimed expenses before amounts relatingto the increased amounts or new providersmay be added to the card.

(4) Example. The following exampleillustrates the rules in this paragraph (g):

Example. Recurring dependent care expenses.(i) Employer K sponsors a dependent care assistanceFSA through its cafeteria plan. Salary reductionamounts for participating employees are made on aweekly payroll basis, which are available for depen-dent care coverage on a weekly basis. As a result,the amount of available dependent care coverageequals the employee’s salary reduction amount mi-nus claims previously paid from the plan. EmployerK has adopted a payment card program for its depen-dent care FSA.

(ii) For the plan year ending December 31, 2009,Employee F is a participant in the dependent careFSA and elected $5,000 of dependent care coverage.Employer K reduces F’s salary by $96.15 on a weeklybasis to pay for coverage under the dependent careFSA.

(iii) At the beginning of the 2009 plan year, F isissued a debit card with a balance of zero. F’s child-care provider, ABC Daycare Center, requires a $250advance payment at the beginning of the week fordependent care services that will be provided duringthe week. The dependent care services provided forF by ABC qualify for reimbursement under section129. However, because as of the beginning of theplan year, no services have yet been provided, F can-not be reimbursed for any of the amounts until the endof the first week of the plan year (that is, the weekending January 5, 2009), after the services have beenprovided.

(iv) F submits a claim for reimbursement that in-cludes a statement from ABC with a description of theservices, the amount of the services, and the dates ofthe services. Employer K increases the balance of F’spayment card to $96.15 after the services have beenprovided (i.e., the lesser of F’s salary reduction to dateor the incurred dependent care expenses). F uses thecard to pay ABC $96.15 on the first day of the nextweek (January 8, 2009) and pays ABC the remainingbalance due for that week ($153.85) by check.

(v) To the extent that this card transaction andeach subsequent transaction is with ABC and is foran amount equal to or less than the previously sub-stantiated amount, the charges are fully substantiated

2007–39 I.R.B. 710 September 24, 2007

without the need for the submission by F of a state-ment from the provider or further review by the em-ployer. However, the subsequent amount is not madeavailable on the card until the end of the week whenthe services have been provided. Employer K’s de-pendent care debit card satisfies the substantiation re-quirements of this paragraph (g).

(h) Effective/applicability date. It isproposed that these regulations apply onand after plan years beginning on or afterJanuary 1, 2009. However, the effectivedates for the previously issued guidance ondebit cards, which is incorporated in thissection, remain applicable.

§1.125–7 Cafeteria plannondiscrimination rules

(a) Definitions—(1) In general. Thedefinitions set forth in this paragraph (a)apply for purposes of section 125(b), (c),(e) and (g) and this section.

(2) Compensation. The term compen-sation means compensation as defined insection 415(c)(3).

(3) Highly compensated individual. (i)In general. The term highly compensatedindividual means an individual who is—

(A) An officer;(B) A five percent shareholder (as de-

fined in paragraph (a)(8) of this section);or

(C) Highly compensated.(ii) Spouse or dependent. A spouse or a

dependent of any highly compensated in-dividual described in (a)(3)(i) of this sec-tion is a highly compensated individual.Section 125(e).

(4) Highly compensated participant.The term highly compensated participantmeans a highly compensated individualwho is eligible to participate in the cafete-ria plan.

(5) Nonhighly compensated individual.The term nonhighly compensated individ-ual means an individual who is not a highlycompensated individual.

(6) Nonhighly compensated partici-pant. The term nonhighly compensatedparticipant means a participant who is nota highly compensated participant.

(7) Officer. The term officer means anyindividual or participant who for the pre-ceding plan year (or the current plan yearin the case of the first year of employment)was an officer. Whether an individual is anofficer is determined based on all the factsand circumstances, including the sourceof the individual’s authority, the term for

which he or she is elected or appointed,and the nature and extent of his or her du-ties. Generally, the term officer means anadministrative executive who is in regu-lar and continued service. The term offi-cer implies continuity of service and ex-cludes individuals performing services inconnection with a special and single trans-action. An individual who merely has thetitle of an officer but not the authority of anofficer, is not an officer. Similarly, an in-dividual without the title of an officer butwho has the authority of an officer is anofficer. Sole proprietorships, partnerships,associations, trusts and labor organizationsalso may have officers. See §§301.7701–1through –3.

(8) Five percent shareholder. A fivepercent shareholder is an individual whoin either the preceding plan year or currentplan year owns more than five percent ofthe voting power or value of all classes ofstock of the employer, determined withoutattribution.

(9) Highly compensated. The termhighly compensated means any individualor participant who for the preceding planyear (or the current plan year in the caseof the first year of employment) had com-pensation from the employer in excessof the compensation amount specified insection 414(q)(1)(B), and, if elected by theemployer, was also in the top-paid groupof employees (determined by reference tosection 414(q)(3)) for such preceding planyear (or for the current plan year in thecase of the first year of employment).

(10) Key employee. A key employee is aparticipant who is a key employee withinthe meaning of section 416(i)(1) at anytime during the preceding plan year. A keyemployee covered by a collective bargain-ing agreement is a key employee.

(11) Collectively bargained plan. Acollectively bargained plan is a plan orthe portion of a plan maintained under anagreement which is a collective bargainingagreement between employee representa-tives and one or more employers, if there isevidence that cafeteria plan benefits werethe subject of good faith bargaining be-tween such employee representatives andsuch employer or employers.

(12) Year of employment. For purposesof section 125(g)(3)(B)(i), a year of em-ployment is determined by reference to theelapsed time method of crediting service.See §1.410(a)–7.

(13) Premium-only-plan. A premium-only-plan is described in paragraph (a)(5)in §1.125–1.

(14) Statutory nontaxable benefits.Statutory nontaxable benefits are qualifiedbenefits that are excluded from gross in-come (for example, an employer-providedaccident and health plan excludible undersection 106 or a dependent care assistanceprogram excludible under section 129).Statutory nontaxable benefits also includegroup-term life insurance on the life ofan employee includible in the employee’sgross income solely because the coverageexceeds the limit in section 79(a).

(15) Total benefits. Total benefits arequalified benefits and permitted taxablebenefits.

(b) Nondiscrimination as to eligibil-ity—(1) In general. A cafeteria planmust not discriminate in favor of highlycompensated individuals as to eligibil-ity to participate for that plan year. Acafeteria plan does not discriminate infavor of highly compensated individualsif the plan benefits a group of employeeswho qualify under a reasonable classi-fication established by the employer, asdefined in §1.410(b)–4(b), and the groupof employees included in the classifica-tion satisfies the safe harbor percentagetest or the unsafe harbor percentage com-ponent of the facts and circumstancestest in §1.410(b)–4(c). (In applying the§1.410(b)–4 test, substitute highly com-pensated individual for highly compen-sated employee and substitute nonhighlycompensated individual for nonhighlycompensated employee).

(2) Deadline for participation in cafe-teria plan. Any employee who has com-pleted three years of employment (andwho satisfies any conditions for partici-pation in the cafeteria plan that are notrelated to completion of a requisite lengthof employment) must be permitted to electto participate in the cafeteria plan no laterthan the first day of the first plan yearbeginning after the date the employeecompleted three years of employment (un-less the employee separates from servicebefore the first day of that plan year).

(3) The safe harbor percentage test. (i)In general. For purposes of the safe har-bor percentage test and the unsafe harborpercentage component of the facts and cir-cumstances test, if the cafeteria plan pro-vides that only employees who have com-

September 24, 2007 711 2007–39 I.R.B.

pleted three years of employment are per-mitted to participate in the plan, employeeswho have not completed three years of em-ployment may be excluded from consider-ation. However, if the cafeteria plan pro-vides that employees are allowed to par-ticipate before completing three years ofemployment, all employees with less thanthree years of employment must be in-cluded in applying the safe harbor percent-age test and the unsafe harbor percentagecomponent of the facts and circumstancestest. See paragraph (g) of this section for apermissive disaggregation rule.

(ii) Employees excluded from consider-ation. In addition, for purposes of the safeharbor percentage test and the unsafe har-bor percentage component of the facts andcircumstances test, the following employ-ees are excluded from consideration —

(A) Employees (except key employees)covered by a collectively bargained planas defined in paragraph (a)(11) of this sec-tion;

(B) Employees who are nonresidentaliens and receive no earned income(within the meaning of section 911(d)(2))from the employer which constitutes in-come from sources within the UnitedStates (within the meaning of section861(a)(3)); and

(C) Employees participating in the cafe-teria plan under a COBRA continuationprovision.

(iv) Examples. The following examplesillustrate the rules in paragraph (b) of thissection:

Example 1. Same qualified benefit for samesalary reduction amount. Employer A has one em-ployer-provided accident and health insurance plan.The cost to participants electing the accident andhealth plan is $10,000 per year for single coverage.All employees have the same opportunity to salaryreduce $10,000 for accident and health plan. Thecafeteria plan satisfies the eligibility test.

Example 2. Same qualified benefit for unequalsalary reduction amounts. Same facts as Example 1except the cafeteria plan offers nonhighly compen-sated employees the election to salary reduce $10,000to pay premiums for single coverage. The cafete-ria plan provides an $8,000 employer flex-credit tohighly compensated employees to pay a portion of thepremium, and provides an election to them to salaryreduce $2,000 to pay the balance of the premium. Thecafeteria plan fails the eligibility test.

Example 3. Accident and health plans of unequalvalue. Employer B’s cafeteria plan offers two em-ployer-provided accident and health insurance plans:Plan X, available only to highly compensated partici-pants, is a low-deductible plan. Plan Y, available onlyto nonhighly compensated participants, is a high de-ductible plan (as defined in section 223(c)(2)). The

annual premium for single coverage under Plan X is$15,000 per year, and $8,000 per year for Plan Y. Em-ployer B’s cafeteria plan provides that highly com-pensated participants may elect salary reduction of$15,000 for coverage under Plan X, and that non-highly compensated participants may elect salary re-duction of $8,000 for coverage under Plan Y. Thecafeteria plan fails the eligibility test.

Example 4. Accident and health plans of unequalvalue for unequal salary reduction amounts. Samefacts as Example 3, except that the amount of salaryreduction for highly compensated participants to electPlan X is $8,000. The cafeteria plan fails the eligibil-ity test.

(c) Nondiscrimination as to contribu-tions and benefits—(1) In general. A cafe-teria plan must not discriminate in favor ofhighly compensated participants as to con-tributions and benefits for a plan year.

(2) Benefit availability and benefit elec-tion. A cafeteria plan does not discrim-inate with respect to contributions andbenefits if either qualified benefits andtotal benefits, or employer contributionsallocable to statutory nontaxable benefitsand employer contributions allocable tototal benefits, do not discriminate in favorof highly compensated participants. Acafeteria plan must satisfy this paragraph(c) with respect to both benefit availabilityand benefit utilization. Thus, a plan mustgive each similarly situated participanta uniform opportunity to elect qualifiedbenefits, and the actual election of quali-fied benefits through the plan must not bedisproportionate by highly compensatedparticipants (while other participants electpermitted taxable benefits). Qualifiedbenefits are disproportionately elected byhighly compensated participants if theaggregate qualified benefits elected byhighly compensated participants, mea-sured as a percentage of the aggregatecompensation of highly compensated par-ticipants, exceed the aggregate qualifiedbenefits elected by nonhighly compen-sated participants measured as a percent-age of the aggregate compensation ofnonhighly compensated participants. Aplan must also give each similarly situ-ated participant a uniform election withrespect to employer contributions, andthe actual election with respect to em-ployer contributions for qualified benefitsthrough the plan must not be dispropor-tionate by highly compensated participants(while other participants elect to receiveemployer contributions as permitted tax-able benefits). Employer contributionsare disproportionately utilized by highly

compensated participants if the aggregatecontributions utilized by highly compen-sated participants, measured as a per-centage of the aggregate compensationof highly compensated participants, ex-ceed the aggregate contributions utilizedby nonhighly compensated participantsmeasured as a percentage of the aggregatecompensation of nonhighly compensatedparticipants.

(3) Example. The following exampleillustrates the rules in paragraph (c) of thissection:

Example. Contributions and benefits test. Em-ployer C’s cafeteria plan satisfies the eligibility testin paragraph (b) of this section. Highly compen-sated participants in the cafeteria plan elect aggre-gate qualified benefits equaling 5 percent of aggre-gate compensation; nonhighly compensated partici-pants elect aggregate qualified benefits equaling 10percent of aggregate compensation. Employer C’scafeteria plan passes the contribution and benefitstest.

(d) Key employees—(1) In general. Iffor any plan year, the statutory nontaxablebenefits provided to key employees exceed25 percent of the aggregate of statutorynontaxable benefits provided for all em-ployees through the cafeteria plan, eachkey employee includes in gross incomean amount equaling the maximum taxablebenefits that he or she could have electedfor the plan year. However, see safe harborfor premium-only-plans in paragraph (f) ofthis section.

(2) Example. The following exampleillustrates the rules in paragraph (d) of thissection:

Example. (i) Key employee concentration test.Employer D’s cafeteria plan offers all employees anelection between taxable benefits and qualified ben-efits. The cafeteria plan satisfies the eligibility testin paragraph (b) of this section. Employer D has twokey employees and four nonhighly compensated em-ployees. The key employees each elect $2,000 ofqualified benefits. Each nonhighly compensated em-ployee also elects $2,000 of qualified benefits. Thequalified benefits are statutory nontaxable benefits.

(ii) Key employees receive $4,000 of statutorynontaxable benefits and nonhighly compensatedemployees receive $8,000 of statutory nontaxablebenefits, for a total of $12,000. Key employeesreceive 33 percent of statutory nontaxable benefits(4,000/12,000). Because the cafeteria plan providesmore than 25 percent of the aggregate of statutorynontaxable benefits to key employees, the plan failsthe key employee concentration test.

(e) Safe harbor for cafeteria plans pro-viding health benefits—(1) In general. Acafeteria plan that provides health benefitsis not treated as discriminatory as to bene-fits and contributions if:

2007–39 I.R.B. 712 September 24, 2007

(i) Contributions under the plan on be-half of each participant include an amountwhich equals 100 percent of the cost ofthe health benefit coverage under the planof the majority of the highly compensatedparticipants similarly situated, or equalsor exceeds 75 percent of the cost of thehealth benefit coverage of the participant(similarly situated) having the highest costhealth benefit coverage under the plan, and

(ii) Contributions or benefits under theplan in excess of those described in para-graph (e)(1)(i) of this section bear a uni-form relationship to compensation.

(2) Similarly situated. In determiningwhich participants are similarly situated,reasonable differences in plan benefitsmay be taken into account (for example,variations in plan benefits offered to em-ployees working in different geographicallocations or to employees with family cov-erage versus employee-only coverage).

(3) Health benefits. Health benefits forpurposes of this rule are limited to majormedical coverage and exclude dental cov-erage and health FSAs.

(4) Example. The following exampleillustrates the rules in paragraph (e) of thissection:

Example. (i) All 10 of Employer E’s employeesare eligible to elect between permitted taxable ben-efits and salary reduction of $8,000 per plan yearfor self-only coverage in the major medical healthplan provided by Employer E. All 10 employees elect$8,000 salary reduction for the major medical plan.

(ii) The cafeteria plan satisfies the section125(g)(2) safe harbor for cafeteria plans provid-ing health benefits.

(f) Safe harbor test for pre-mium-only-plans—(1) In general. Apremium-only-plan (as defined in para-graph (a)(13) of this section) is deemed tosatisfy the nondiscrimination rules in sec-tion 125(c) and this section for a plan yearif, for that plan year, the plan satisfies thesafe harbor percentage test for eligibilityin paragraph (b)(3) of this section.

(2) Example. The following exampleillustrates the rules in paragraph (f) of thissection:

Example. Premium-only-plan. (i) Employer F’scafeteria plan is a premium-only-plan (as defined inparagraph (a)(13) of this section). The written cafe-teria plan offers one employer-provided accident andhealth plan and offers all employees the election tosalary reduce same amount or same percentage ofthe premium for self-only or family coverage. Allkey employees and all highly compensated employ-ees elect salary reduction for the accident and healthplan, but only 20 percent of nonhighly compensatedemployees elect the accident and health plan.

(ii) The premium-only-plan satisfies the nondis-crimination rules in section 125(b) and (c) and thissection.

(g) Permissive disaggregation fornondiscrimination testing—(1) Generalrule. If a cafeteria plan benefits employ-ees who have not completed three years ofemployment, the cafeteria plan is permit-ted to test for nondiscrimination under thissection as if the plan were two separateplans—

(i) One plan benefiting the employeeswho completed one day of employmentbut less than three years of employment;and

(ii) Another plan benefiting the employ-ees who have completed three years of em-ployment.

(2) Disaggregated plans tested sepa-rately for eligibility test and contributionsand benefits test. If a cafeteria plan is dis-aggregated into two separate plans for pur-poses of nondiscrimination testing, the twoseparate plans must be tested separately forboth the nondiscrimination as to eligibilitytest in paragraph (b) of this section and thenondiscrimination as to contributions andbenefits test in paragraph (c) of this sec-tion.

(h) Optional aggregation of plans fornondiscrimination testing. An employerwho sponsors more than one cafeteria planis permitted to aggregate two or more ofthe cafeteria plans for purposes of nondis-crimination testing. If two or more cafe-teria plans are aggregated into a combinedplan for this purpose, the combined planmust satisfy the nondiscrimination as to el-igibility test in paragraph (b) of this sectionand the nondiscrimination as to contribu-tions and benefits test in paragraph (c) ofthis section, as though the combined planwere a single plan. Thus, for example, inorder to satisfy the benefit availability andbenefit election requirements in paragraph(c)(2) of this section, the combined planmust give each similarly situated partici-pant a uniform opportunity to elect qual-ified benefits and the actual election ofqualified benefits by highly compensatedparticipants must not be disproportionate.However, if a principal purpose of the ag-gregation is to manipulate the nondiscrimi-nation testing requirements or to otherwisediscriminate in favor of highly compen-sated individuals or participants, the planswill not be permitted to be aggregated fornondiscrimination testing.

(i) Employees of certain controlledgroups. All employees who are treatedas employed by a single employer undersection 414(b), (c), (m), or (o) are treatedas employed by a single employer for pur-poses of section 125. Section 125(g)(4);section 414(t).

(j) Time to perform nondiscriminationtesting—(1) In general. Nondiscrimina-tion testing must be performed as of thelast day of the plan year, taking into ac-count all non-excludable employees (orformer employees) who were employeeson any day during the plan year.

(2) The following example illustratesthe rules in paragraph (j) of this section:

Example. When to perform discrimination test-ing. (i) Employer H employs three employees andmaintains a calendar year cafeteria plan. During the2009 plan year, Employee J was an employee theentire calendar year, Employee K was an employeefrom May 1, through August 31, 2009, and EmployeeL worked from January 1, 2009 to April 15, 2009,when he retired.

(ii) Nondiscrimination testing for the 2009 planyear must be performed on December 31, 2009, tak-ing into account employees J, K, and L’s compensa-tion in the preceding year.

(k) Discrimination in actual operationprohibited. In addition to not discriminat-ing as to either benefit availability or bene-fit utilization, a cafeteria plan must not dis-criminate in favor of highly compensatedparticipants in actual operation. For exam-ple, a plan may be discriminatory in ac-tual operation if the duration of the plan(or of a particular nontaxable benefit of-fered through the plan) is for a period dur-ing which only highly compensated partic-ipants utilize the plan (or the benefit). Seealso the key employee concentration test insection 125(b)(2).

(l) Anti-abuse rule—(1) Interpretation.The provisions of this section must be in-terpreted in a reasonable manner consis-tent with the purpose of preventing dis-crimination in favor of highly compen-sated individuals, highly compensated par-ticipants and key employees.

(2) Change in plan testing procedures.A plan will not be treated as satisfying therequirements of this section if there are re-peated changes to plan testing proceduresor plan provisions that have the effect ofmanipulating the nondiscrimination test-ing requirements of this section, if a princi-pal purpose of the changes was to achievethis result.

(m) Tax treatment of benefits in acafeteria plan—(1) Nondiscriminatory

September 24, 2007 713 2007–39 I.R.B.

cafeteria plan. A participant in a nondis-criminatory cafeteria plan (including ahighly compensated participant or keyemployee) who elects qualified benefits isnot treated as having received taxable ben-efits offered through the plan, and thus thequalified benefits elected by the employeeare not includible in the employee’s grossincome merely because of the availabilityof taxable benefits. But see paragraph (j)in §1.125–1 on nondiscrimination rulesfor sections 79(d), 105(h), 129(d), and137(c)(2), and limitations on exclusion.

(2) Discriminatory cafeteria plan. Ahighly compensated participant or keyemployee participating in a discrimina-tory cafeteria plan must include in grossincome (in the participant’s taxable yearwithin which ends the plan year with re-spect to which an election was or couldhave been made) the value of the taxablebenefit with the greatest value that theemployee could have elected to receive,even if the employee elects to receive onlythe nontaxable benefits offered.

(n) Employer contributions to employ-ees’ Health Savings Accounts. If an em-ployer contributes to employees’ HealthSavings Accounts (HSAs) through a cafe-teria plan (as defined in §54.4980G–5of this chapter) those contributions aresubject to the nondiscrimination rules insection 125 and this section and are notsubject to the comparability rules in sec-tion 4980G. See §§54.4980G–0 through54.4980G–5 of this chapter.

(o) Effective/applicability date. It isproposed that these regulations apply onand after plan years beginning on or afterJanuary 1, 2009.



Notice of ProposedRulemaking and Notice ofPublic Hearing

Medical and AccidentInsurance Benefits UnderQualified Plans

REG–148393–06


ACTION: Notice of proposed rulemakingand notice of public hearing.

SUMMARY: This document contains pro-posed regulations under section 402(a) ofthe Internal Revenue Code (Code) regard-ing the tax treatment of payments by qual-ified plans for medical or accident insur-ance. These regulations would affect ad-ministrators of, participants in, and benefi-ciaries of qualified retirement plans. Thisdocument also provides notice of a publichearing on these proposed regulations.

DATES: Written or electronic commentsmust be received by November 19, 2007.Outlines of topics to be discussed at thepublic hearing scheduled for December 6,2007, at 10 a.m., must be received byNovember 15, 2007.

ADDRESSES: Send submissions to:CC:PA:LPD:PR (REG–148393–06),room 5203, Internal Revenue Ser-vice, PO Box 7604, Ben Franklin Sta-tion, Washington, DC 20044. Submis-sions may be hand-delivered Mondaythrough Friday between the hours of8 a.m. and 4 p.m. to CC:PA:LPD:PR(REG–148393–06), Courier’s Desk, In-ternal Revenue Service, 1111 ConstitutionAvenue, NW, Washington, DC, or sentelectronically via the Federal eRulemak-ing Portal at www.regulations.gov (IRSREG–148393–06). The public hearingwill be held in the IRS Auditorium, Inter-nal Revenue Service, 1111 ConstitutionAvenue, NW, Washington, DC.

FOR FURTHER INFORMATIONCONTACT: Concerning the proposedregulations, Pamela R. Kinard (202)622–6060; concerning submissions ofcomments, the hearing, and/or to be placedon the building access list to attend the

hearing, Kelly Banks, (202) 622–7180(not toll-free numbers).


Background

This document contains proposedamendments to 26 CFR part 1 undersection 402(a) of the Code, as well as con-forming amendments under sections 72,105, 106, 401, 402(c), 403(a), and 403(b).

Section 104(a)(3) provides, in gen-eral, that gross income does not includeamounts received through accident orhealth insurance (or through an arrange-ment having the effect of accident orhealth insurance) for personal injuries orsickness. This exclusion does not applyto amounts attributable to (and not in ex-cess of) deductions allowed under section213 for any prior taxable year, or to otheramounts received by an employee to theextent such amounts either are attributableto contributions by the employer that werenot includible in the gross income of theemployee or are paid by the employer.

Section 105(a) provides that, except asotherwise provided, amounts received byan employee through accident or health in-surance for personal injuries or sicknessare included in gross income to the extentsuch amounts (1) are attributable to con-tributions by the employer which were notincludible in the gross income of the em-ployee or (2) are paid by the employer.

Section 105(b) generally provides that,except in the case of amounts attributableto deductions allowed under section 213for any prior taxable year, gross incomedoes not include amounts referred to insection 105(a) if such amounts are paid,directly or indirectly, to the taxpayer to re-imburse the taxpayer for expenses incurredby the taxpayer for the medical care of thetaxpayer and his or her spouse or depen-dents.

Section 106 provides that the gross in-come of an employee does not include em-ployer-provided coverage under an acci-dent or health plan. Section 1.106–1 pro-vides that the gross income of an employeedoes not include contributions that the em-ployer makes to an accident or health planfor compensation (through insurance or aseparate trust or fund) for personal injuriesor sickness to the employee or the em-ployee’s spouse or dependents.

2007–39 I.R.B. 714 September 24, 2007

Section 7702B(a)(1) provides that, forpurposes of the Code, a qualified long-term care insurance contract is treated asan accident and health insurance contract.

Section 213 generally allows a deduc-tion for expenses paid during the taxableyear, not compensated for by insurance orotherwise, for medical care of the taxpayer,his or her spouse, and dependents, to theextent that the expenses exceed 7.5 percentof the taxpayer’s adjusted gross income.Section 213(d)(1) provides that the term“medical care” includes amounts paid forinsurance covering medical care (includ-ing eligible long-term care premiums withrespect to qualified long-term care insur-ance contracts).

Section 401(a) sets forth requirementsfor a trust forming part of a pension, profit-sharing, or stock bonus plan to be qualifiedunder section 401(a).

Section 401(h) provides that a pensionor annuity plan may provide for the pay-ment of benefits for sickness, accident,hospitalization, and medical expenses ofretired employees, their spouses and theirdependents only if certain enumeratedconditions are met. Those conditionsinclude: (1) the aggregate actual contri-butions for medical benefits (when addedto actual contributions for life insuranceprotection under the plan) may not exceed25 percent of the total actual contributionsto the plan (other than contributions tofund past service credits) after the dateon which the account is established; (2)a separate account must be establishedand maintained for such benefits; (3) theemployer’s contributions to the separateaccount must be reasonable and ascertain-able; (4) it must be impossible, at any timeprior to the satisfaction of all liabilities un-der the plan to provide such benefits, forany part of the corpus or income of suchseparate account to be (within the taxableyear or thereafter) used for, or diverted to,any purpose other than the providing ofsuch benefits; (5) any amount remainingafter satisfaction of all liabilities must,under the terms of the plan, be returned tothe employer; and (6) special limitationsfor the accounts of key employees must besatisfied.

Section 402(a) provides, in general, thatany amount actually distributed by a qual-

ified plan is taxable under section 72 in thetaxable year in which distributed.

Section 72(a) provides that, exceptas otherwise provided, gross income in-cludes any amount received as an annuity(whether for a period certain or during oneor more lives) under an annuity, endow-ment, or life insurance contract. Sections72(d) and (e) provide rules for determiningthe portion of any distribution that is notincludable in gross income as a recovery ofa participant’s investment in the contract(generally the amount of the unrecoveredafter-tax employee contributions) under aqualified employer retirement plan.

Section 402(l), added by section 845(a)of the Pension Protection Act of 2006,Public Law 109–280 (120 Stat. 780)(PPA ’06), provides a limited exclusionfrom gross income for distributions froman eligible retirement plan used to payhealth or long-term care insurance pre-miums of an eligible retired public safetyofficer to the extent that the aggregateamount of the distributions for the taxableyear is not in excess of the qualified healthinsurance premiums of the retired publicsafety officer and his or her spouse or de-pendents. The total amount excluded fromgross income pursuant to section 402(l)shall not exceed $3,000.

Section 1.72–15 provides rules relatingto the tax treatment of amounts paid froman employer-established plan to whichsection 72 applies and which provides fordistributions of accident or health ben-efits. With respect to benefits that areattributable to employer contributions,§1.72–15(d) provides that any amountreceived as an accident or health bene-fit is includible in gross income, exceptto the extent excludable from gross in-come under section 105(b) (relating toreimbursements of medical care expensesas defined in section 213(d)).1 Section1.72–15(e) provides that the taxability ofbenefits that are not accident or healthbenefits is determined under section 72without regard to any exclusion undersection 104 or 105.

Section 1.401–1(b)(1)(i) provides that aplan is not a pension plan within the mean-ing of section 401(a) if it provides for thepayment of benefits not customarily in-cluded in a pension plan such as layoff ben-

efits or benefits for sickness, accident, hos-pitalization, or medical expenses (exceptfor medical benefits described in section401(h)). See §1.401(a)–1(b)(1)(ii).

Section 1.401–1(b)(1)(ii) provides thata profit-sharing plan within the meaningof section 401(a) is primarily a plan ofdeferred compensation, but that amountsallocated to the account of a participantmay be used to provide incidental life oraccident or health insurance for the partic-ipant and the participant’s family. Section1.401–1(b)(1)(iii) provides that a stockbonus plan is a plan established and main-tained by the employer to provide benefitssimilar to those of a profit-sharing plan.

Rev. Rul. 61–164, 1961–2 C.B. 99, see§601.601(d)(2) of this chapter, holds that aprofit-sharing plan does not violate the in-cidental benefit rule in §1.401–1(b)(1)(ii)merely because, in accordance with theterms of the plan, each participant’s ac-count under the plan is charged with thecost of health insurance for the participantunder group hospitalization insurance forthe employer’s employees, provided thatthe total amount used for life or accident orhealth insurance for the employee and theemployee’s family is incidental. The rul-ing concludes that such insurance is treatedas incidental if the amount expended doesnot exceed 25 percent of the funds allo-cated to a participant’s account that havenot been accumulated for the period pre-scribed by the plan for the deferment ofdistributions. The ruling also concludesthat the use of profit-sharing plan funds topay for medical insurance for a participantand his or her beneficiary is a distributionwithin the meaning of section 402.

Rev. Rul. 73–501, 1973–2 C.B. 127,see §601.601(d)(2) of this chapter, appliesthe incidental benefit rule to the purchaseof life insurance by a profit-sharing plan.The ruling states that “[u]nder a qualifiedprofit-sharing plan, the use of trust fundsto pay the cost of life, accident, or healthinsurance for an employee is a distributionwithin the purview of section 402 of theCode.”

Rev. Rul. 2003–62, 2003–1 C.B. 1034,see §601.601(d)(2) of this chapter, con-cludes that amounts distributed from aqualified retirement plan that the distribu-tee elects to have applied to pay health

1 Section 1.72–15(d) also refers to benefits excludible under section 105(c) (relating to certain payments unrelated to absence from work) or 105(d), which was repealed in 1983 (and whichrelated to certain disability payments).

September 24, 2007 715 2007–39 I.R.B.

insurance premiums under a cafeteria planare includible in the distributee’s grossincome. The ruling also holds that thesame conclusion applies where amountsdistributed from the plan are applied di-rectly to reimburse medical care expensesincurred by a participant.

Rev. Rul. 2005–55, 2005–2 C.B. 284,see §601.601(d)(2) of this chapter, holdsthat a profit-sharing plan that providesa sub-account which permits distribu-tions only for the purpose of reimbursingthe participant for substantiated medicalexpenses imposes conditions on the en-titlement of the participant to amountsheld in the sub-account and, as a result ofthe conditions, does not meet the nonfor-feitability requirements of section 411.

Explanation of Provisions

The proposed regulations would clarifythat a payment from a qualified plan for anaccident or health insurance premium gen-erally constitutes a distribution under sec-tion 402(a) that is taxable to the distribu-tee under section 72 in the taxable year inwhich the premium is paid. The taxableamount generally equals the amount of thepremium charged against the participant’sbenefits under the plan. If a defined con-tribution plan pays these premiums from acurrent year contribution or forfeiture thathas not been allocated to a participant’s ac-count, then the amount of the premium foreach participant will be treated as first be-ing allocated to the participant and thencharged against the participant’s benefitsunder the plan, so that the amount of thedistribution is the same as determined un-der the preceding sentence.

These regulations would also providethat a distribution for the payment of thepremiums by a qualified plan generally isnot excluded from gross income under sec-tion 104, 105, or 106, but such distributionwould constitute an amount paid for acci-dent or health insurance under section 213.Furthermore, to the extent that the paymentof premiums for accident or health insur-ance has been treated as a distribution froma qualified plan, amounts received throughthe accident or health insurance for per-

sonal injuries or sickness are excludablefrom gross income under section 104(a)(3)and are not treated as distributions from theplan.

A related issue is whether the purchaseof accident and health insurance can betreated as if the trust merely purchased aninvestment under which an insurer’s pay-ments for medical expenses are made tothe trust and then treated as a return onthat investment. The proposed regulationswould clarify that payments from accidentor health insurance for medical expensesthat are made to the trust (rather than madeto the medical service provider or the par-ticipant as reimbursement for covered ex-penses) are treated as having been made tothe participant and then contributed by theparticipant to the plan. Comments are re-quested on whether there should be limitedexceptions to this general rule (such as anexception for a provision that has the ef-fect of a waiver of premium in the case ofdisability).

The proposed regulations wouldnot alter the incidental benefit rule of§1.401–1(b)(1)(ii) (which provides that aprofit-sharing plan may provide incidentallife or accident or health insurance for theparticipant and the participant’s family)nor would they alter the tax treatment ofthe payment of life insurance. For the taxtreatment of payments for life insurance,see section 72(m)(3) and §1.72–16.

The general rule that accident andhealth insurance premiums are taxabledistributions would not apply to amountsheld under a medical account that satisfiesall the requirements of section 401(h).Accident or health insurance purchasedthrough a section 401(h) account doesnot constitute a taxable distribution. See§1.72–15(h), providing that employercontributions to provide medical benefitsin a section 401(h) account under a qual-ified plan or annuity are not includiblein the gross income of the employee onwhose behalf contributions were made.2

The result is the same if the section 401(h)account is funded with a transfer from aqualified pension plan in accordance withsection 420. Similarly, section 402(l), as

added by PPA ’06, permits an exclusionfrom gross income, up to $3,000 annually,for distributions paid directly to an insurerto purchase accident or health insuranceor qualified long-term care insurance foran eligible retired public safety officerand his or her spouse or dependents. Theexistence of narrow exceptions for retireemedical benefits under section 401(h) andfor distributions for the payment of pre-miums on behalf of eligible retired publicsafety officers under section 402(l) is con-sistent with a general rule for inclusion ingross income of the payments of premi-ums for accident and health insurance.

Section 402(a) provides that amountsactually distributed from a qualified planare generally taxable to the distributeein the year of the distribution. There isno general exception in section 402 fora distribution in the form of accident orhealth insurance.3 Moreover, Congresshas carefully prescribed and strictly lim-ited the ability to pre-fund accident andhealth insurance benefits on a tax-favoredbasis. The rules specifically prescribedby Congress relating to the pre-fundingof future health benefits on a tax-favoredbasis include the rules in section 223(providing contribution limits and distri-bution rules for health savings accounts(HSAs)); sections 419 and 419A (limitingemployer deductions for contributions towelfare benefit funds); section 501(c)(9)(providing requirements for tax-exemptVoluntary Employee Beneficiary Associ-ations (VEBAs)); section 512 (providingfor the taxation of a VEBA’s unrelatedbusiness income); and by sections 401(h)and 420 (governing retiree health benefitsprovided through a separate health ben-efits account that is part of a pension orannuity plan). Therefore, because Con-gress specifically prescribed these limitedprovisions for favorable tax-treatment, abroad exclusion permitting tax-favoredtreatment of any distribution used to payaccident or health insurance premiumswould be inconsistent with this intentionalstatutory scheme.

In addition, the existence of the inciden-tal benefit rule in §1.401–1(b)(1)(ii) is not

2 See also H.R. Rep. No. 2317, 87th

Cong., 2nd

Sess. at 4 (1962), stating that no part of the contributions paid by the employer to a section 401(h) account will be taxed currently to theemployee.

3 See, for example, the Joint Committee on Taxation’s Technical Explanation, Technical Explanation of H.R. 4, the “Pension Protection Act of 2006” as passed by the House on July 28, 2006,and Considered by the Senate on August 3, 2006 (JCX–38–06), August 3, 2006, 109

thCong., 2

ndSess. 244 (2006), relating to the exception under section 402(l), which states that, under

present law, distributions from a qualified plan are generally included in gross income (subject to exceptions for investment in the contract and qualified distributions from a designated Rothaccount).

2007–39 I.R.B. 716 September 24, 2007

an indication that distributions used to pro-vide incidental life or accident or health in-surance benefits are eligible for tax-favor-able treatment because the incidental bene-fit rule relates solely to the qualification ofa profit-sharing plan, not to the tax treat-ment of amounts used to provide medicalor accident insurance benefits under suchplan.

The proposed regulations also containconforming amendments to the IncomeTax Regulations under sections 72, 105,106, 401, and 402(c). These conformingamendments would remove obsolete pro-visions, as well as cite to the rules in theseproposed regulations for determining thetax treatment of the payment of premiumsfor accident and health insurance from aqualified plan. Conforming amendmentsunder sections 403(a) and 403(b) wouldalso add a cross-reference to the regu-lations under section 403(a) and section403(b) that would apply the rules in theseproposed regulations to those arrange-ments. In addition, the proposed regula-tions would revise the first sentence of§1.106–1 in order to update the definitionof dependent in light of section 207 of theWorking Families Tax Relief Act of 2004,Pub. L. No. 108–311 (118 Stat. 1166)and Notice 2004–79, 2004–2 C.B. 898,see §601.601(d)(2). The proposed reg-ulations would also amend §1.402(c)–2,Q&A–4 to add distributions of premiumsfor accident or health insurance under§1.402(a)–1(e)(1) to the list of items thatare not eligible rollover contributions. Fi-nally, these proposed regulations wouldalso include a cross-reference to section402(l), as added by PPA ’06. For ad-ditional guidance on section 402(l), seeNotice 2007–7, 2007–5 I.R.B 395, see§601.601(d)(2).

Proposed Effective Date

It is expected that the regulations willapply for calendar years after the publi-cation of final regulations in the FederalRegister. However, no inference shouldbe drawn that the payment of premiumsfrom a qualified plan does not constitutea taxable distribution if made prior to theeffective date of these regulations.

Special Analyses

It has been determined that this noticeof proposed rulemaking is not a significant

regulatory action as defined in ExecutiveOrder 12866. Therefore, a regulatory as-sessment is not required. It also has beendetermined that section 553(b) of the Ad-ministrative Procedure Act (5 U.S.C. chap-ter 5) does not apply to these regulations,and because these regulations do not im-pose a collection of information on smallentities, the Regulatory Flexibility Act (5U.S.C. chapter 6) does not apply. Pursuantto section 7805(f) of the Code, this pro-posed regulation has been submitted to theChief Counsel for Advocacy of the SmallBusiness Administration for comment onits impact on small business.

Comments and Public Hearing

Before these proposed regulations areadopted as final regulations, considerationwill be given to any written (a signed origi-nal and eight (8) copies) or electronic com-ments that are submitted timely to the IRS.The Treasury Department and the IRS re-quest comments on the clarity of the pro-posed rules and how they may be madeeasier to understand. All comments will beavailable for public inspection and copy-ing.

A public hearing has been scheduled forDecember 6, 2007, beginning at 10 a.m. inthe Auditorium, Internal Revenue Service,1111 Constitution Avenue, N.W., Wash-ington, DC. Due to building security pro-cedures, visitors must enter at the Consti-tution Avenue entrance. In addition, allvisitors must present photo identificationto enter the building. Because of accessrestrictions, visitors will not be admittedbeyond the immediate entrance area morethan 30 minutes before the hearing starts.For information about having your nameplaced on the building access list to attendthe hearing, see the “FOR FURTHER IN-FORMATION CONTACT” section of thispreamble.

The rules of 26 CFR 601.601(a)(3) ap-ply to the hearing. Persons who wish topresent oral comments at the hearing mustsubmit written or electronic comments byNovember 19, 2007, and an outline of thetopics to be discussed and the amount oftime to be devoted to each topic (a signedoriginal and eight (8) copies) by Novem-ber 15, 2007. A period of 10 minutes willbe allotted to each person for making com-ments. An agenda showing the schedulingof the speakers will be prepared after the

deadline for receiving outlines has passed.Copies of the agenda will be available freeof charge at the hearing.


The principal authors of these reg-ulations are Pamela R. Kinard andMichael P. Brewer, Office of DivisionCounsel/Associate Chief Counsel (TaxExempt and Government Entities). How-ever, other personnel from the IRS and theTreasury Department participated in theirdevelopment.

* * * * *

Proposed Amendments to theRegulations

Accordingly, 26 CFR part 1 is proposedto be amended as follows:

PART—INCOME TAXES

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

Authority: 26 U.S.C. 7805 * * *Par. 2. Section 1.72–15 is amended by:1. Revising paragraphs (d), (h), and (i).2. Removing paragraph (f).The revisions read as follows:

§1.72–15 Applicability of section 72 toaccident or health plans.

* * * * *(d) Accident or health benefits attrib-

utable to employer contributions. Anyamounts received as accident or healthbenefits and not attributable to contri-butions of the employee are includible ingross income except to the extent that suchamounts are excludable from gross incomeunder section 105(b) or (c) and the regu-lations thereunder. See §1.402(a)–1(e) forrules relating to the use of a qualified planunder section 401(a) to pay premiums foraccident or health insurance.

* * * * *(h) Medical benefits for retired employ-

ees, etc. See §1.402(a)–1(e)(2) for rulesrelating to the payment of medical benefitsdescribed in section 401(h) under a quali-fied pension or annuity plan.

(i) Special rules—(1) In general. Forpurposes of section 72(b) and (d), and thissection, the taxpayer shall maintain suchrecords as are necessary to substantiate the

September 24, 2007 717 2007–39 I.R.B.

amount treated as an investment in the tax-payer’s annuity contract.

(2) Delegation to Commissioner. TheCommissioner may prescribe a form andinstructions with respect to the taxpayer’spast and current treatment of amounts re-ceived under section 72 or 105, and the tax-payer’s computation, or recomputation, ofthe taxpayer’s investment in his or her an-nuity contract. This form may be requiredto be filed with the taxpayer’s returns foryears in which such amounts are excludedunder section 72 or 105.

§1.105–4 [Removed]

Par. 3. Section 1.105–4 is removed.

§1.105–6 [Removed]

Par. 4. Section 1.105–6 is removed.Par. 5. Section 1.106–1 is amended

by revising the first sentence and addinga new sentence at the end of the paragraphto read as follows:

§1.106–1 Contributions by employer toaccident and health plans.

The gross income of an employee doesnot include the contributions which theemployer makes to an accident or healthplan for compensation (through insuranceor otherwise) to the employee for personalinjuries or sickness incurred by the em-ployee, the employee’s spouse, or the em-ployee’s dependents (as defined in section152 determined without regard to section152(b)(1), (b)(2), or (d)(1)(B)).

* * *For the treatment of the payment of

premiums for accident or health insurancefrom a qualified trust under section 401(a),see §§1.72–15 and 1.402(a)–1(e).

Par. 6. Section 1.401–1 is amendedby adding a new sentence at the end ofparagraph (b)(1)(ii) to read as follows:

§1.401–1 Qualified pension,profit-sharing, and stock bonus plans.

* * * * *(b) * * * (1)(i) * * *(ii) * * * See §§1.72–15, 1.72–16, and

1.402(a)–1(e) for rules regarding the taxtreatment of incidental life or accident orhealth insurance.

Par. 7. Section 1.402(a)–1 is amendedby removing the last two sentences of para-

graph (a)(1)(ii) and adding a new sentencein their place and by adding a new para-graph (e) to read as follows:

§1.402(a)–1 Taxability of beneficiaryunder a trust which meets the requirementsof section 401(a).

(a) * * * (1)(i) * * *(ii) * * * Paragraph (e) of this section

provides rules relating to use of a qualifiedpension, annuity, profit-sharing, or stockbonus plan to provide accident or healthbenefits or coverage otherwise describedin section 104, 105, or 106.

* * * * *(e) Medical, accident, etc., benefits

paid from a qualified pension, annuity,profit-sharing, or stock bonus plan—(1)Payment of premiums—(i) General rule.The payment of premiums from a quali-fied trust for accident or health insurance,including a qualified long-term care insur-ance contract under section 7702B, con-stitutes a distribution under section 402(a)to the participant against whose benefitthe premium is charged. The amount ofthe distribution equals the amount of thepremium charged against the participant’sbenefits under the plan. If a defined con-tribution plan pays these premiums from acurrent year contribution or forfeiture thathas not been allocated to a participant’saccount, then the amount of the premiumfor each participant will be treated as firstbeing allocated to the participant and thencharged against the participant’s benefitsunder the plan, so that the amount of thedistribution is treated in the same manneras determined under the preceding sen-tence. Except as described in paragraphs(e)(2) and (3) of this section, a distributiondescribed in this paragraph (e)(1) is notexcludable from gross income.

(ii) Treatment of amounts receivedthrough accident or health insurance.To the extent that the premium for ac-cident or health insurance constitutes adistribution under this paragraph (e)(1),amounts received through accident orhealth insurance are neither attributableto contributions by the employer whichare not includible in the gross income ofthe employee nor are such amounts paidby the employer. Accordingly, amountsreceived through the accident or healthinsurance for personal injuries or sicknessare excludable from gross income under

section 104(a)(3) and are not treated asdistributions from the plan. If amountsreceived through accident or health in-surance are paid to the plan instead ofthe employee, these amounts are treatedas having been paid to the employee andthen contributed by the employee to theplan (and these amounts must satisfy thequalification requirements applicable toemployee contributions).

(2) Medical benefits for retired employ-ees provided under an account describedin section 401(h). The payment of medi-cal benefits described in section 401(h) un-der a pension or annuity plan is treated inthe same manner as a payment of accidentor health benefits attributable to employercontributions, or employer-provided cov-erage under an accident or health plan. See§1.401–14(a) for the definition of medi-cal benefits described in section 401(h).Accordingly, amounts applied for the pay-ment of accident or health benefits, or forthe payment of accident or health cover-age, from a section 401(h) account are notincludible in the gross income of the par-ticipant on whose behalf such contribu-tions are made to the extent they are ex-cludible from gross income under section104, 105, or 106.

(3) Distributions to eligible retired pub-lic safety officers. See section 402(l) fora limited exclusion from gross income fordistributions used to pay for certain acci-dent or health premiums (including premi-ums for qualified long-term care insurancecontracts). This limited exclusion appliesto eligible retired public safety officers, asdefined in section 402(l)(4)(B).

(4) Effect of making a distribution of in-surance premiums on qualification. See§1.401–1(b)(1) for rules concerning thetypes and amount of medical coverage andbenefits that are permitted to be providedunder a plan that is part of a trust de-scribed in section 401(a). For example,§1.401–1(b)(1)(ii) provides that a profit-sharing plan is primarily a plan of de-ferred compensation, but the amounts al-located to the account of a participant maybe used to provide incidental accident orhealth insurance for the participant andthe participant’s family. See also, section401(k)(2)(B) for certain restrictions on thedistribution of elective contributions.

(5) Application of this paragraph (e).This paragraph (e) applies to the paymentof premiums charged against the benefits

2007–39 I.R.B. 718 September 24, 2007

of a beneficiary or an alternate payee inthe same manner as the payment of premi-ums charged against the account of a par-ticipant.

(6) Example. The provisions of thisparagraph (e) are illustrated by the follow-ing example:

Example. (i) Facts. Employer sponsors a profit-sharing plan qualified under section 401(a). The planprovides solely for non-elective employer profit-shar-ing contributions. The plan’s trustee enters into acontract with a third-party insurance carrier to pro-vide health insurance for certain plan participants.The insurance policy provides for the payment ofmedical expenses incurred by those participants. Theplan limits the amounts used to provide medical ben-efits with respect to a participant to 25 percent of thefunds held in the participant’s account. The trusteemakes monthly payments of $1,000 to pay the pre-miums due for Participant A’s health insurance. Thetrustee also reduces Participant A’s account balanceby $1,000 at the time of each premium payment. InJune of a year, Participant A is admitted to the hospi-tal for covered medical care, and in July of the sameyear, the health insurer pays the hospital $5,000 forthe medical care provided to Participant A in June.

(ii) Conclusion. Under paragraph (e)(1) of thissection, each of the trustee’s payments of $1,000 con-stitutes a distribution under section 402(a) to Partic-ipant A on the date of each payment. To the extentprovided under section 213, the amount of these dis-tributions constitutes payments for medical care. The$5,000 payment to the hospital is excludable fromParticipant A’s gross income under section 104(a)(3)and is not treated as a distribution from the plan.

Par. 8. Section 1.402(c)–2 is amendedby redesignating paragraphs A–4(g) andA–4(h) as paragraphs A–4(h) and A–4(i)and adding a new paragraph A–4(g) to readas follows:

§1.402(c)–2 Eligible rollovercontributions; questions and answers.

* * * * *A–4: * * *(g) Distributions of premiums for

accident or health insurance under§1.402(a)–1(e).

* * * * *Par. 9. Section 1.403(a)–1 is amended

by revising paragraph (g) to read as fol-lows:

§1.403(a)–1 Taxability of beneficiaryunder a qualified annuity plan.

* * * * *(g) The rules of §1.402(a)–1(e) apply

for purposes of determining the treatmentof amounts paid to provide accident andhealth insurance benefits.

Par. 10. Section 1.403(b)–6 is amendedby adding a sentence following the firstsentence of paragraph (g) to read as fol-lows:

§1.403(b)–6 Timing of distributions andbenefits.

* * * * * (g) Death benefits and otherincidental benefits. * * * The rules of§1.402(a)–1(e) apply for purposes of de-termining when incidental benefits aretreated as distributed and included in grossincome. See §§1.72–15 and 1.72–16.* * *

* * * * *

Linda E. Stiff,Acting Deputy Commissionerfor Services and Enforcement.


Employer ComparableContributions to HealthSavings Accounts UnderSection 4980G; HearingCancellation

Announcement 2007–85


ACTION: Cancellation of notice of publichearing on proposed rulemaking.

SUMMARY: This document cancels apublic hearing on proposed regulations(REG–143797–06, 2007–26 I.R.B. 1495)providing guidance on employer com-parable contributions to Health SavingsAccounts (HSAs).

DATES: The public hearing, originallyscheduled for September 28, 2007 at10 a.m. is cancelled.

FOR FURTHER INFORMATIONCONTACT: Kelly Banks of the Publi-cations and Regulations Branch, LegalProcessing Division, Associate ChiefCounsel (Procedure and Administration)at (202) 622–0392 (not a toll-free num-ber).

SUPPLEMENTARY INFORMATION: Anotice of proposed rulemaking and noticeof public hearing that appeared in the Fed-eral Register on Friday, June 1, 2007 (72FR 30501), announced that a public hear-ing was scheduled for September 28, 2007,at 10 a.m. in the IRS Auditorium, InternalRevenue Service, 1111 Constitution Av-enue, NW, Washington, DC. The subject ofthe public hearing is under section 4980Gof the Internal Revenue Code.

The public comment period for theseregulations expired on August 30, 2007.The notice of proposed rulemaking and no-tice of public hearing instructed those in-terested in testifying at the public hearingto submit a request to speak and an out-line of the topics to be addressed by August28, 2007. As of September 6, 2007, noone has requested to speak and therefore,the public hearing scheduled for Septem-ber 28, 2007, is cancelled.

LaNita Van Dyke,Branch Chief,

Publications and Regulations Branch,Legal Processing Division,

Associate Chief Counsel(Procedure and Administration).

(Filed by the Office of the Federal Register on September12, 2007, 8:45 a.m., and published in the issue of the FederalRegister for September 13, 2007, 72 F.R. 52319)

Deletions From CumulativeList of OrganizationsContributions to Whichare Deductible Under Section170 of the Code

Announcement 2007–86

The names of organizations that nolonger qualify as organizations describedin section 170(c)(2) of the Internal Rev-enue Code of 1986 are listed below.

Generally, the Service will not disallowdeductions for contributions made to alisted organization on or before the dateof announcement in the Internal RevenueBulletin that an organization no longerqualifies. However, the Service is notprecluded from disallowing a deductionfor any contributions made after an or-ganization ceases to qualify under section170(c)(2) if the organization has not timelyfiled a suit for declaratory judgment under

September 24, 2007 719 2007–39 I.R.B.

section 7428 and if the contributor (1) hadknowledge of the revocation of the rulingor determination letter, (2) was aware thatsuch revocation was imminent, or (3) wasin part responsible for or was aware of theactivities or omissions of the organizationthat brought about this revocation.

If on the other hand a suit for declara-tory judgment has been timely filed, con-tributions from individuals and organiza-tions described in section 170(c)(2) thatare otherwise allowable will continue tobe deductible. Protection under section7428(c) would begin on September 24,2007, and would end on the date the courtfirst determines that the organization is notdescribed in section 170(c)(2) as more par-

ticularly set forth in section 7428(c)(1).For individual contributors, the maximumdeduction protected is $1,000, with a hus-band and wife treated as one contributor.This benefit is not extended to any indi-vidual, in whole or in part, for the acts oromissions of the organization that were thebasis for revocation.

Museum of American PianoBangor, PA

Transitional Living CollaborativeMoraga, CA

Ken-Ray, IncorporatedOrem, UT

DreamHome FoundationSherwood, OR

Creativity InnovationProductivity Incorporated DBAHorizon Event FoundationHighwood, MT

Community Fellowship for BatteredWomen of Silicon Valley, Inc.San Jose, CA

Alta Crossing, Inc.Nampa, ID

Home Buyers Assistance Foundation, Inc.Denver, CO

International Housing Solutions, Inc.Sacramento, CA

Filipino American CommunityDevelopment Council, Inc.San Jose, CA

2007–39 I.R.B. 720 September 24, 2007

Definition of TermsRevenue rulings and revenue procedures(hereinafter referred to as “rulings”) thathave an effect on previous rulings use thefollowing defined terms to describe the ef-fect:

Amplified describes a situation whereno change is being made in a prior pub-lished position, but the prior position is be-ing extended to apply to a variation of thefact situation set forth therein. Thus, ifan earlier ruling held that a principle ap-plied to A, and the new ruling holds that thesame principle also applies to B, the earlierruling is amplified. (Compare with modi-fied, below).

Clarified is used in those instanceswhere the language in a prior ruling is be-ing made clear because the language hascaused, or may cause, some confusion.It is not used where a position in a priorruling is being changed.

Distinguished describes a situationwhere a ruling mentions a previously pub-lished ruling and points out an essentialdifference between them.

Modified is used where the substanceof a previously published position is beingchanged. Thus, if a prior ruling held that aprinciple applied to A but not to B, and thenew ruling holds that it applies to both A

and B, the prior ruling is modified becauseit corrects a published position. (Comparewith amplified and clarified, above).

Obsoleted describes a previously pub-lished ruling that is not considered deter-minative with respect to future transac-tions. This term is most commonly used ina ruling that lists previously published rul-ings that are obsoleted because of changesin laws or regulations. A ruling may alsobe obsoleted because the substance hasbeen included in regulations subsequentlyadopted.

Revoked describes situations where theposition in the previously published rulingis not correct and the correct position isbeing stated in a new ruling.

Superseded describes a situation wherethe new ruling does nothing more than re-state the substance and situation of a previ-ously published ruling (or rulings). Thus,the term is used to republish under the1986 Code and regulations the same po-sition published under the 1939 Code andregulations. The term is also used whenit is desired to republish in a single rul-ing a series of situations, names, etc., thatwere previously published over a period oftime in separate rulings. If the new rul-ing does more than restate the substance

of a prior ruling, a combination of termsis used. For example, modified and su-perseded describes a situation where thesubstance of a previously published rulingis being changed in part and is continuedwithout change in part and it is desired torestate the valid portion of the previouslypublished ruling in a new ruling that is selfcontained. In this case, the previously pub-lished ruling is first modified and then, asmodified, is superseded.

Supplemented is used in situations inwhich a list, such as a list of the names ofcountries, is published in a ruling and thatlist is expanded by adding further names insubsequent rulings. After the original rul-ing has been supplemented several times, anew ruling may be published that includesthe list in the original ruling and the ad-ditions, and supersedes all prior rulings inthe series.

Suspended is used in rare situationsto show that the previous published rul-ings will not be applied pending somefuture action such as the issuance of newor amended regulations, the outcome ofcases in litigation, or the outcome of aService study.

AbbreviationsThe following abbreviations in current useand formerly used will appear in materialpublished in the Bulletin.

A—Individual.Acq.—Acquiescence.B—Individual.BE—Beneficiary.BK—Bank.B.T.A.—Board of Tax Appeals.C—Individual.C.B.—Cumulative Bulletin.CFR—Code of Federal Regulations.CI—City.COOP—Cooperative.Ct.D.—Court Decision.CY—County.D—Decedent.DC—Dummy Corporation.DE—Donee.Del. Order—Delegation Order.DISC—Domestic International Sales Corporation.DR—Donor.E—Estate.EE—Employee.E.O.—Executive Order.

ER—Employer.ERISA—Employee Retirement Income Security Act.EX—Executor.F—Fiduciary.FC—Foreign Country.FICA—Federal Insurance Contributions Act.FISC—Foreign International Sales Company.FPH—Foreign Personal Holding Company.F.R.—Federal Register.FUTA—Federal Unemployment Tax Act.FX—Foreign corporation.G.C.M.—Chief Counsel’s Memorandum.GE—Grantee.GP—General Partner.GR—Grantor.IC—Insurance Company.I.R.B.—Internal Revenue Bulletin.LE—Lessee.LP—Limited Partner.LR—Lessor.M—Minor.Nonacq.—Nonacquiescence.O—Organization.P—Parent Corporation.PHC—Personal Holding Company.PO—Possession of the U.S.PR—Partner.

PRS—Partnership.PTE—Prohibited Transaction Exemption.Pub. L.—Public Law.REIT—Real Estate Investment Trust.Rev. Proc.—Revenue Procedure.Rev. Rul.—Revenue Ruling.S—Subsidiary.S.P.R.—Statement of Procedural Rules.Stat.—Statutes at Large.T—Target Corporation.T.C.—Tax Court.T.D. —Treasury Decision.TFE—Transferee.TFR—Transferor.T.I.R.—Technical Information Release.TP—Taxpayer.TR—Trust.TT—Trustee.U.S.C.—United States Code.X—Corporation.Y—Corporation.Z —Corporation.

September 24, 2007 i 2007–39 I.R.B.

Numerical Finding List1

Bulletins 2007–27 through 2007–39

Announcements:

2007-61, 2007-28 I.R.B. 84

2007-62, 2007-29 I.R.B. 115

2007-63, 2007-30 I.R.B. 236

2007-64, 2007-29 I.R.B. 125

2007-65, 2007-30 I.R.B. 236

2007-66, 2007-31 I.R.B. 296

2007-67, 2007-32 I.R.B. 345

2007-68, 2007-32 I.R.B. 348

2007-69, 2007-33 I.R.B. 371

2007-70, 2007-33 I.R.B. 371

2007-71, 2007-33 I.R.B. 372

2007-72, 2007-33 I.R.B. 373

2007-73, 2007-34 I.R.B. 435

2007-74, 2007-35 I.R.B. 483

2007-75, 2007-36 I.R.B. 540

2007-76, 2007-36 I.R.B. 560

2007-77, 2007-38 I.R.B. 662

2007-78, 2007-38 I.R.B. 663

2007-80, 2007-38 I.R.B. 667

2007-81, 2007-38 I.R.B. 667

2007-85, 2007-39 I.R.B. 719

2007-86, 2007-39 I.R.B. 719

Notices:

2007-54, 2007-27 I.R.B. 12

2007-55, 2007-27 I.R.B. 13

2007-56, 2007-27 I.R.B. 15

2007-57, 2007-29 I.R.B. 87

2007-58, 2007-29 I.R.B. 88

2007-59, 2007-30 I.R.B. 135

2007-60, 2007-35 I.R.B. 466

2007-61, 2007-30 I.R.B. 140

2007-62, 2007-32 I.R.B. 331

2007-63, 2007-33 I.R.B. 353

2007-64, 2007-34 I.R.B. 385

2007-65, 2007-34 I.R.B. 386

2007-66, 2007-34 I.R.B. 387

2007-67, 2007-35 I.R.B. 467

2007-68, 2007-35 I.R.B. 468

2007-69, 2007-35 I.R.B. 468

2007-71, 2007-35 I.R.B. 472

2007-72, 2007-36 I.R.B. 544

2007-73, 2007-36 I.R.B. 545

2007-74, 2007-37 I.R.B. 585

2007-75, 2007-39 I.R.B. 679

Proposed Regulations:

REG-121475-03, 2007-35 I.R.B. 474

REG-128274-03, 2007-33 I.R.B. 356

REG-114084-04, 2007-33 I.R.B. 359

REG-149036-04, 2007-33 I.R.B. 365

Proposed Regulations— Continued:

REG-149036-04, 2007-34 I.R.B. 411

REG-101001-05, 2007-36 I.R.B. 548

REG-119097-05, 2007-28 I.R.B. 74

REG-128843-05, 2007-37 I.R.B. 587

REG-142695-05, 2007-39 I.R.B. 681

REG-147171-05, 2007-32 I.R.B. 334

REG-148951-05, 2007-36 I.R.B. 550

REG-163195-05, 2007-33 I.R.B. 366

REG-118886-06, 2007-37 I.R.B. 591

REG-128224-06, 2007-36 I.R.B. 551

REG-138707-06, 2007-32 I.R.B. 342

REG-139268-06, 2007-34 I.R.B. 415

REG-142039-06, 2007-34 I.R.B. 415

REG-144540-06, 2007-31 I.R.B. 296

REG-148393-06, 2007-39 I.R.B. 714

REG-103842-07, 2007-28 I.R.B. 79

REG-116215-07, 2007-38 I.R.B. 659

REG-118719-07, 2007-37 I.R.B. 593

Revenue Procedures:

2007-42, 2007-27 I.R.B. 15

2007-43, 2007-27 I.R.B. 26

2007-44, 2007-28 I.R.B. 54

2007-45, 2007-29 I.R.B. 89

2007-46, 2007-29 I.R.B. 102

2007-47, 2007-29 I.R.B. 108

2007-48, 2007-29 I.R.B. 110

2007-49, 2007-30 I.R.B. 141

2007-50, 2007-31 I.R.B. 244

2007-51, 2007-30 I.R.B. 143

2007-52, 2007-30 I.R.B. 222

2007-53, 2007-30 I.R.B. 233

2007-54, 2007-31 I.R.B. 293

2007-55, 2007-33 I.R.B. 354

2007-56, 2007-34 I.R.B. 388

2007-57, 2007-36 I.R.B. 547

2007-58, 2007-37 I.R.B. 585

2007-60, 2007-39 I.R.B. 679

Revenue Rulings:

2007-42, 2007-28 I.R.B. 44

2007-43, 2007-28 I.R.B. 45

2007-44, 2007-28 I.R.B. 47

2007-45, 2007-28 I.R.B. 49

2007-46, 2007-30 I.R.B. 126

2007-47, 2007-30 I.R.B. 127

2007-48, 2007-30 I.R.B. 129

2007-49, 2007-31 I.R.B. 237

2007-50, 2007-32 I.R.B. 311

2007-51, 2007-37 I.R.B. 573

2007-52, 2007-37 I.R.B. 575

2007-53, 2007-37 I.R.B. 577

2007-54, 2007-38 I.R.B. 604

2007-55, 2007-38 I.R.B. 604

2007-56, 2007-39 I.R.B. 668

Revenue Rulings— Continued:

2007-57, 2007-36 I.R.B. 531

2007-58, 2007-37 I.R.B. 562

2007-59, 2007-37 I.R.B. 582

2007-60, 2007-38 I.R.B. 606

Tax Conventions:

2007-75, 2007-36 I.R.B. 540

Treasury Decisions:

9326, 2007-31 I.R.B. 242

9327, 2007-28 I.R.B. 50

9328, 2007-27 I.R.B. 1

9329, 2007-32 I.R.B. 312

9330, 2007-31 I.R.B. 239

9331, 2007-32 I.R.B. 298

9332, 2007-32 I.R.B. 300

9333, 2007-33 I.R.B. 350

9334, 2007-34 I.R.B. 382

9335, 2007-34 I.R.B. 380

9336, 2007-35 I.R.B. 461

9337, 2007-35 I.R.B. 455

9338, 2007-35 I.R.B. 463

9339, 2007-35 I.R.B. 437

9340, 2007-36 I.R.B. 487

9341, 2007-35 I.R.B. 449

9342, 2007-35 I.R.B. 451

9343, 2007-36 I.R.B. 533

9344, 2007-36 I.R.B. 535

9345, 2007-36 I.R.B. 523

9346, 2007-37 I.R.B. 570

9347, 2007-38 I.R.B. 624

9348, 2007-37 I.R.B. 563

9349, 2007-39 I.R.B. 668

9350, 2007-38 I.R.B. 607

9351, 2007-38 I.R.B. 616

9352, 2007-38 I.R.B. 621

9355, 2007-37 I.R.B. 577

9356, 2007-39 I.R.B. 675

1 A cumulative list of all revenue rulings, revenue procedures, Treasury decisions, etc., published in Internal Revenue Bulletins 2007–1 through 2007–26 is in Internal Revenue Bulletin2007–26, dated June 25, 2007.

2007–39 I.R.B. ii September 24, 2007

Finding List of Current Actions onPreviously Published Items1

Bulletins 2007–27 through 2007–39

Announcements:

84-26

Obsoleted by

T.D. 9336, 2007-35 I.R.B. 461

84-37

Obsoleted by

T.D. 9336, 2007-35 I.R.B. 461

Notices:

89-110

Modified by

REG-142695-05, 2007-39 I.R.B. 681

99-6

Obsoleted as of January 1, 2009 by

T.D. 9356, 2007-39 I.R.B. 675

2002-45

Modified by

REG-142695-05, 2007-39 I.R.B. 681

2003-81

Modified and supplemented by

Notice 2007-71, 2007-35 I.R.B. 472

2006-43

Modified by

T.D. 9332, 2007-32 I.R.B. 300

2006-56

Clarified by

Notice 2007-74, 2007-37 I.R.B. 585

2006-89

Modified by

Notice 2007-67, 2007-35 I.R.B. 467

2007-3

Modified by

Notice 2007-69, 2007-35 I.R.B. 468

2007-26

Modified by

Notice 2007-56, 2007-27 I.R.B. 15

Proposed Regulations:

EE-16-79

Withdrawn by

REG-142695-05, 2007-39 I.R.B. 681

EE-130-86

Withdrawn by

REG-142695-05, 2007-39 I.R.B. 681

REG-243025-96

Withdrawn by

REG-142695-05, 2007-39 I.R.B. 681

Proposed Regulations— Continued:

REG-117162-99

Withdrawn by

REG-142695-05, 2007-39 I.R.B. 681

REG-157711-02

Corrected by

Ann. 2007-74, 2007-35 I.R.B. 483

REG-119097-05

Hearing location change by

Ann. 2007-81, 2007-38 I.R.B. 667

REG-109367-06

Hearing scheduled by

Ann. 2007-66, 2007-31 I.R.B. 296

REG-143601-06

Corrected by

Ann. 2007-71, 2007-33 I.R.B. 372

REG-143797-06

Cancellation of hearing by

Ann. 2007-85, 2007-39 I.R.B. 719

REG-103842-07

Corrected by

Ann. 2007-77, 2007-38 I.R.B. 662

Revenue Procedures:

90-27

Superseded by

Rev. Proc. 2007-52, 2007-30 I.R.B. 222

95-28

Superseded by

Rev. Proc. 2007-54, 2007-31 I.R.B. 293

97-14

Modified and superseded by

Rev. Proc. 2007-47, 2007-29 I.R.B. 108

2002-9

Modified and amplified by

Rev. Proc. 2007-48, 2007-29 I.R.B. 110Rev. Proc. 2007-53, 2007-30 I.R.B. 233

2004-42

Superseded by

Notice 2007-59, 2007-30 I.R.B. 135

2005-16

Modified by

Rev. Proc. 2007-44, 2007-28 I.R.B. 54

2005-27

Superseded by

Rev. Proc. 2007-56, 2007-34 I.R.B. 388

2005-66

Clarified, modified, and superseded by

Rev. Proc. 2007-44, 2007-28 I.R.B. 54

2006-25

Superseded by

Rev. Proc. 2007-42, 2007-27 I.R.B. 15

Revenue Procedures— Continued:

2006-27

Modified by

Rev. Proc. 2007-49, 2007-30 I.R.B. 141

2006-33

Superseded by

Rev. Proc. 2007-51, 2007-30 I.R.B. 143

2006-53

Modified by

Rev. Proc. 2007-60, 2007-39 I.R.B. 679

2006-55

Superseded by

Rev. Proc. 2007-43, 2007-27 I.R.B. 26

2007-4

Modified by

Notice 2007-69, 2007-35 I.R.B. 468

2007-15

Superseded by

Rev. Proc. 2007-50, 2007-31 I.R.B. 244

Revenue Rulings:

54-378

Clarified by

Rev. Rul. 2007-51, 2007-37 I.R.B. 573

67-93

Obsoleted by

T.D. 9347, 2007-38 I.R.B. 624

69-141

Modified by

REG-142695-05, 2007-39 I.R.B. 681

74-299

Amplified by

Rev. Rul. 2007-48, 2007-30 I.R.B. 129

75-425

Obsoleted by

Rev. Rul. 2007-60, 2007-38 I.R.B. 606

76-450

Obsoleted by

T.D. 9347, 2007-38 I.R.B. 624

78-257

Obsoleted by

T.D. 9347, 2007-38 I.R.B. 624

78-369

Revoked by

Rev. Rul. 2007-53, 2007-37 I.R.B. 577

89-96

Amplified by

Rev. Rul. 2007-47, 2007-30 I.R.B. 127

92-17

Modified by

Rev. Rul. 2007-42, 2007-28 I.R.B. 44

1 A cumulative list of current actions on previously published items in Internal Revenue Bulletins 2007–1 through 2007–26 is in Internal Revenue Bulletin 2007–26, dated June 25, 2007.

September 24, 2007 iii 2007–39 I.R.B.

Revenue Rulings— Continued:

94-62

Supplemented by

Rev. Rul. 2007-58, 2007-37 I.R.B. 562

2001-48

Modified by

T.D. 9332, 2007-32 I.R.B. 300

2002-41

Modified by

REG-142695-05, 2007-39 I.R.B. 681

2003-102

Modified by

REG-142695-05, 2007-39 I.R.B. 681

2005-24

Modified by

REG-142695-05, 2007-39 I.R.B. 681

2006-36

Modified by

REG-142695-05, 2007-39 I.R.B. 681

2007-59

Amplified by

Notice 2007-74, 2007-37 I.R.B. 585

Treasury Decisions:

8073

Removed by

T.D. 9349, 2007-39 I.R.B. 668

9321

Corrected by

Ann. 2007-68, 2007-32 I.R.B. 348Ann. 2007-78, 2007-38 I.R.B. 663

9330

Corrected by

Ann. 2007-80, 2007-38 I.R.B. 667

2007–39 I.R.B. iv September 24, 2007

INDEXInternal Revenue Bulletins 2007–27 through2007–39

The abbreviation and number in parenthesis following the index entryrefer to the specific item; numbers in roman and italic type followingthe parenthesis refers to the Internal Revenue Bulletin in which the itemmay be found and the page number on which it appears.

Key to Abbreviations:Ann AnnouncementCD Court DecisionDO Delegation OrderEO Executive OrderPL Public LawPTE Prohibited Transaction ExemptionRP Revenue ProcedureRR Revenue RulingSPR Statement of Procedural RulesTC Tax ConventionTD Treasury DecisionTDO Treasury Department Order

EMPLOYEE PLANSBona fide severance pay plan under section 457(e)(11) and sub-

stantial risk of forfeiture under section 457(f) (Notice 62) 32,331

Cafeteria plans under section 125, guidance (REG–142695–05)39, 681

Determination letters, staggered remedial amendments (RP 44)28, 54

Disclosure requirements with respect to prohibited tax sheltertransactions (TD 9335) 34, 380

Employee Plans Compliance Resolution System (EPCRS), cor-rection program (RP 49) 30, 141

Form 5500, Schedule P, elimination (Ann 63) 30, 236Full funding limitations, weighted average interest rate for:

July 2007 (Notice 61) 30, 140August 2007 (Notice 68) 35, 468September 2007 (Notice 75) 39, 679

Indian tribal government, Pension Protection Act of 2006 (Notice67) 35, 467

Individual retirement accounts (IRAs), deemed IRAs in govern-mental plans/qualified nonbank trustee rules (TD 9331) 32,298

Mortality tables for determining present value, correction toREG–143601–06 (Ann 71) 33, 372

Nonexempt employees’ trusts, income and employment tax con-sequences (RR 48) 30, 129

Nonqualified deferred compensation plans, application of sec-tion 409A, correction to TD 9321 (Ann 68) 32, 348; additionalcorrection to TD 9321 (Ann 78) 38, 663

Proposed Regulations:26 CFR 1.72–15, amended; 1.105–4, –6, removed; 1.106–1,

amended; 1.401–1, amended; 1.402(a)–1, amended;1.402(c)–2, amended; 1.403(a)–1, amended; 1.403(b)–6,

EMPLOYEE PLANS—Cont.amended; medical and accident insurance benefits underqualified plans (REG–148393–06) 39, 714

26 CFR 1.125–0, –1, –2, –5, –6, –7, added; employee benefits– cafeteria plans (REG–142695–05) 39, 681

26 CFR 1.430(h)(3)–2, amended; mortality tables for deter-mining present value, correction to REG–143601–06 (Ann71) 33, 372

26 CFR 1.6033–5, added; 53.4965–1 thru –9, added;53.6071–1, amended; 54.6011–1, amended;301.6011(g)–1, added; 301.6033–5, added; excisetaxes on prohibited tax shelter transactions and related dis-closure requirements, disclosure requirements with respectto prohibited tax shelter transactions, requirement of returnand time for filing (REG–142039–06; REG–139268–06)34, 415

Qualified retirement plans:Pension plans, normal retirement age (Notice 69) 35, 468Pre-approved defined benefit plans, GUST amendments (Ann

61) 28, 84Regulations:

26 CFR 1.402(b)–1, amended; 1.402(g)(3)–1, added;1.402A–1, revised; 1.403(b)–0, added; 1.403(b)–1, –2,–3, revised; 1.403(b)–4 thru –11, added; 1.403(d)–1,removed; 1.414(c)–5 redesignated as 1.414(c)–6; new1.414(c)–5, added; 602.101, amended; revised regulationsconcerning section 403(b) tax-sheltered annuity contracts(TD 9340) 36, 487

26 CFR 1.408–2(e)(8), revised; 1.408–2T, removed; deemedIRAs in governmental plans/qualified nonbank trustee rules(TD 9331) 32, 298

26 CFR 1.409A–1, –2, –3, –6, amended; application of sec-tion 409A to nonqualified deferred compensation plans;correction to TD 9321 (Ann 78) 38, 663

26 CFR 1.6033–5T, added; 301.6033–5T, added; disclosurerequirements with respect to prohibited tax shelter transac-tions (TD 9335) 34, 380

26 CFR 53.6011–1, amended; 53.6071–1, amended;53.6071–1T, added; 54.6011–1, –1T, amended; require-ment of return and time for filing (TD 9334) 34, 382

Requirement of return and time for filing with respect to section4965 taxes (TD 9334) 34, 382; (REG–142039–06) 34, 415;(REG–139268–06) 34, 415

Tax-sheltered annuities, section 403(b) contracts (TD 9340) 36,487

Terminations and partial terminations, turnover of employees,presumption (RR 43) 28, 45

Use of qualified plan amounts to pay health insurance premiums(REG–148393–06) 39, 714

EMPLOYMENT TAXAmerican Jobs Creation Act (AJCA), modifications to the sec-

tion 6011 regulations (TD 9350) 38, 607Disregarded entities, employment and excise taxes (TD 9356)

39, 675

September 24, 2007 v 2007–39 I.R.B.

EMPLOYMENT TAX—Cont.Liens, changes to office to which notices of nonjudicial sale and

requests for return of wrongfully levied property must be sent(TD 9344) 36, 535; (REG–148951–05) 36, 550

Nonexempt employees’ trusts, income and employment tax con-sequences (RR 48) 30, 129

Penalties, transitional relief for the return preparer penalty pro-visions under section 6694 (Notice 54) 27, 12

Proposed Regulations:26 CFR 301.6343–2, amended; 301.7425–3, amended;

changes to office to which notices of nonjudicial sale andrequests for return of wrongfully levied property must besent (REG–148951–05) 36, 550

Publications:1141, General Rules and Specifications for Substitute Forms

W-2 and W-3, revised (RP 43) 27, 264436, General Rules and Specifications for Substitute Form

941 and Schedule B (Form 941), revised (RP 42) 27, 15Regulations:

26 CFR 1.34–1, revised; 1.34–2 thru –6, removed; 1.1361–4,–6, amended; 301.7701–2, amended; disregarded entities,employment and excise taxes (TD 9356) 39, 675

26 CFR 1.6011–4, revised; 1.6011–4T, removed; 20.6011–4,revised; 25.6011–4, revised; 31.6011–4, revised;53.6011–4, revised; 54.6011–4, revised; 56.6011–4,revised; AJCA modifications to the section 6011 regula-tions (TD 9350) 38, 607

26 CFR 31.3402(f)(2)–1, (f)(5)–1, amended;31.3402(f)(2)–1T, (f)(5)–1T, removed; withholdingexemptions (TD 9337) 35, 455

26 CFR 301.6343–2, amended; 301.6343–2T, added;301.7425–3, amended; 301.7425–3T, added; changesto office to which notices of nonjudicial sale and requestsfor return of wrongfully levied property must be sent (TD9344) 36, 535

Substitute forms:W-2 and W-3, general rules and specifications (RP 43) 27, 26941 and Schedule B (Form 941), general rules and specifica-

tions (RP 42) 27, 15Withholding exemptions (TD 9337) 35, 455

ESTATE TAXAmerican Jobs Creation Act (AJCA), modifications to the sec-

tion 6011 regulations (TD 9350) 38, 607Charitable lead annuity trust (CLAT):

Inter vivos, sample forms (RP 45) 29, 89Testamentary, sample form (RP 46) 29, 102

Generation-skipping transfer (GST) tax:Qualified severance of a trust (TD 9348) 37, 563Severance of a trust for GST tax purposes II

(REG–128843–05) 37, 587Grantor retained interest trusts, application of sections 2036 and

2039 (REG–119097–05) 28, 74; hearing location change (Ann81) 38, 667

ESTATE TAX—Cont.Interest rates for 2007, farm real property, special use value (RR

45) 28, 49Liens, changes to office to which notices of nonjudicial sale and



Proposed Regulations:26 CFR 20.2036–1, amended; 20.2039–1, amended; grantor

retained interest trusts-application of sections 2036 and2039 (REG–119097–05) 28, 74; hearing location change(Ann 81) 38, 667

26 CFR 26.2600–1, amended; 26.2642–6, amended;26.2654–1, amended; severance of a trust for gen-eration-skipping transfer (GST) tax purposes II(REG–128843–05) 37, 587

26 CFR 301.6343–2, amended; 301.7425–3, amended;changes to office to which notices of nonjudicial sale andrequests for return of wrongfully levied property must besent (REG–148951–05) 36, 550

Regulations:26 CFR 1.1001–1, amended; 26.2600–1, amended;

26.2642–6, added; 26.2654–1, amended; 602.101,amended; qualified severance of a trust for genera-tion-skipping transfer (GST) tax purposes (TD 9348) 37,563



EXCISE TAXAmerican Jobs Creation Act (AJCA), modifications to the sec-

tion 6011 regulations (TD 9350) 38, 607Disclosure requirements with respect to prohibited tax shelter

transactions (TD 9335) 34, 380Disregarded entities, employment and excise taxes (TD 9356)

39, 675Liens, changes to office to which notices of nonjudicial sale and



Proposed Regulations:26 CFR 1.6033–5, added; 53.4965–1 thru –9, added;

53.6071–1, amended; 54.6011–1, amended;301.6011(g)–1, added; 301.6033–5, added; excisetaxes on prohibited tax shelter transactions and related dis-

2007–39 I.R.B. vi September 24, 2007

EXCISE TAX—Cont.closure requirements, disclosure requirements with respectto prohibited tax shelter transactions, requirement of returnand time for filing (REG–142039–06; REG–139268–06)34, 415


Regulations:26 CFR 1.34–1, revised; 1.34–2 thru –6, removed; 1.1361–4,

–6, amended; 301.7701–2, amended; disregarded entities,employment and excise taxes (TD 9356) 39, 675



26 CFR 48.4081–1, –3, –5, amended; 48.4081–1T, –3T, re-moved; 602.101, amended; entry of taxable fuel (TD 9346)37, 570




Taxable fuel, entry into the United States (TD 9346) 37, 570

EXEMPT ORGANIZATIONSAmerican Jobs Creation Act (AJCA), modifications to the sec-

tion 6011 regulations (TD 9350) 38, 607Disclosure requirements with respect to prohibited tax shelter

transactions (TD 9335) 34, 380Information and materials made available for public inspection

(REG–116215–07) 38, 659Letter rulings and determination letters, exemption application

determination letter rulings under sections 501 and 521 (RP52) 30, 222

List of organizations classified as private foundations (Ann 67)32, 345

Proposed Regulations:26 CFR 1.6033–5, added; 53.4965–1 thru –9, added;

53.6071–1, amended; 54.6011–1, amended;301.6011(g)–1, added; 301.6033–5, added; excisetaxes on prohibited tax shelter transactions and related dis-closure requirements, disclosure requirements with respect

EXEMPT ORGANIZATIONS—Cont.to prohibited tax shelter transactions, requirement of returnand time for filing (REG–142039–06; REG–139268–06)34, 415

26 CFR 301.6104(a)–1, amended; 301.6110–1, amended;public inspection of material relating to tax-exempt orga-nizations (REG–116215–07) 38, 659

Regulations:26 CFR 1.402(b)–1, amended; 1.402(g)(3)–1, added;

1.402A–1, revised; 1.403(b)–0, added; 1.403(b)–1, –2,–3, revised; 1.403(b)–4 thru –11, added; 1.403(d)–1,removed; 1.414(c)–5 redesignated as 1.414(c)–6; new1.414(c)–5, added; 602.101, amended; revised regulationsconcerning section 403(b) tax-sheltered annuity contracts(TD 9340) 36, 487





Revocations (Ann 64) 29, 125; (Ann 65) 30, 236; (Ann 69) 33,371; (Ann 73) 34, 435; (Ann 76) 36, 560; (Ann 86) 39, 719

Suspension of tax-exempt status of organizations identified withterrorism (Ann 70) 33, 371


GIFT TAXAmerican Jobs Creation Act (AJCA), modifications to the sec-

tion 6011 regulations (TD 9350) 38, 607Charitable lead annuity trust (CLAT), inter vivos, sample forms

(RP 45) 29, 89Liens, changes to office to which notices of nonjudicial sale and





Regulations:26 CFR 1.6011–4, revised; 1.6011–4T, removed; 20.6011–4,

revised; 25.6011–4, revised; 31.6011–4, revised;53.6011–4, revised; 54.6011–4, revised; 56.6011–4,

September 24, 2007 vii 2007–39 I.R.B.

GIFT TAX—Cont.revised; AJCA modifications to the section 6011 regula-tions (TD 9350) 38, 607


INCOME TAXAccounting methods:

Automatic consent to change, Advance Trade DiscountMethod (RP 53) 30, 233

Safe harbor method of accounting for rotable spare parts (RP48) 29, 110

Accounts and notes receivable, section 1221(a)(4) capital assetexclusion, hearing (Ann 66) 31, 296

Agent for a consolidated group with foreign common parent (TD9343) 36, 533

American Jobs Creation Act (AJCA):Modifications to the section 6011 regulations (TD 9350) 38,

607Modifications to the section 6111 regulations (TD 9351) 38,

616Modifications to the section 6112 regulations (TD 9352) 38,

621Cafeteria plans under section 125, removal of temporary regula-

tions TD 8073 (TD 9349) 39, 668Charitable contribution of real property, deduction (Notice 72)

36, 544Charitable lead annuity trust (CLAT):

Inter vivos, sample forms (RP 45) 29, 89Testamentary, sample form (RP 46) 29, 102

Commodity Credit Corporation (CCC) loans, tax treatment andinformation reporting of repayments (Notice 63) 33, 353

Corporations:Consolidated returns, unified rule for loss on subsidiary stock,

correction to REG–157711–02 (Ann 74) 35, 483Corporate reorganizations:

Active trade or business requirement for spin offs, distri-butions under section 355 (Notice 60) 35, 466

Spin offs, distributions under section 355 (RR 42) 28, 44Estimated tax payments by corporations (TD 9347) 38, 624Exclusions from gross income of foreign corporations (TD

9332) 32, 300; (REG–138707–06) 32, 342Information returns required with respect to certain foreign

corporations and certain foreign-owned domestic corpora-tions (TD 9338) 35, 463

Real estate investment trust (REIT) distributions subject tosection 897(h)(1) (Notice 55) 27, 13

Section 382 treatment of prepaid income under built-in gainprovisions of section 382(h) (TD 9330) 31, 239; correction(Ann 80) 38, 667; (REG–144540–06) 31, 296

INCOME TAX—Cont.Credits:

Clean renewable energy bonds, volume cap, change of ad-dress (Notice 56) 27, 15

Enhanced oil recovery credit, 2007 inflation adjustment (No-tice 64) 34, 385

Low-income housing credit:Carryovers to qualified states, 2007 National Pool (RP 55)

33, 354Guidance on application of the qualified contract provi-

sions of section 42 (REG–114084–04) 33, 359Guidance on temporary relief of certain section 42 require-

ments as a result of major disasters declared by the Pres-ident (RP 54) 31, 293

Satisfactory bond, “bond factor” amounts for the period:January through September 2007 (RR 46) 30, 126

Time extension for restoration of certain low-income hous-ing credit projects located within the Gulf OpportunityZone damaged by Hurricane Katrina (Notice 66) 34, 387

Utility allowances under section 42 (REG–128274–03) 33,356

Overpayments, tax liabilities:Outstanding amounts, bankruptcy (RR 52) 37, 575Unassessed amounts, notice of deficiency (RR 51) 37, 573

Disciplinary actions involving attorneys, certified public accoun-tants, enrolled agents, and enrolled actuaries (Ann 72) 33, 373

Disclosure of returns and return information in connection withwritten contracts or agreements for the acquisition of propertyor services for tax administrative purposes (TD 9327) 28, 50

Electronic filing and burden reduction, guidance (TD 9329) 32,312

Entertainment use of business aircraft (REG–147171–05) 32,334

Estates or trusts, section 67 limitations (REG–128224–06) 36,551

Financial services income under section 904(d), request for com-ments (Notice 58) 29, 88

Forms:1096, 1098, 1099, 5498, W-2G, and 1042-S, substitute form

specifications (RP 50) 31, 2441098, 1099, 5498 and W-2G, requirements for filing electron-

ically or magnetically, 2007 revision (RP 51) 30, 1431118, Foreign Tax Credit – Corporations, comments requested

on proposed revisions (Ann 62) 29, 115Gambling winnings, reporting requirements (RP 57) 36, 547Health Savings Accounts (HSAs), employer comparable contri-

butions to HSAs under section 4980G, cancellation of hearingon REG–143797–06 (Ann 85) 39, 719

Hurricane Katrina filers, time for filing postponed to April 15,2007, extension of time (Notice 74) 37, 585

Inflation adjusted amounts under section 179 of the Code, cor-rection (RP 60) 39, 679

2007–39 I.R.B. viii September 24, 2007

INCOME TAX—Cont.Insurance companies:

Diversification requirements under section 817(REG–118719–07) 37, 593

Inevitable future costs as insurance risk (RR 47) 30, 127Life insurance, reserves for variable life insurance contracts

and required interest under section 807(d)(2) (RR 54) 38,604

Minimum effectively connected income, foreign insurancecompany, guidance regarding computation of amount (RP58) 37, 585

Treatment of certain nondiversified contracts, qualified pen-sion or retirement contracts (RR 58) 37, 562

Interest:Investment:

Federal short-term, mid-term, and long-term rates for:July 2007 (RR 44) 28, 47August 2007 (RR 50) 32, 311September 2007 (RR 57) 36, 531

Rates:Underpayments and overpayments, quarter beginning:

October 1, 2007 (RR 56) 39, 668Suspension of interest:

General rules and exceptions (REG–149036–04) 34, 411Listed transactions (TD 9333) 33, 350; (REG–149036–04)

33, 365Liens, changes to office to which notices of nonjudicial sale and


Life-nonlife tacking rule, taxable years of members of consoli-dated groups (TD 9342) 35, 451

Listed transaction, loss importation transaction (Notice 57) 29,87

Losses, deductions for abandoned stock or securities(REG–101001–05) 36, 548

Marginal production rates, 2007 (Notice 65) 34, 386Nonexempt employees’ trusts, income and employment tax con-

sequences (RR 48) 30, 129Partnerships, subpart F income (TD 9326) 31, 242Payment card transactions, procedure for payment card organi-

zation to obtain Qualified Payment Card Agent (QPCA) deter-mination (Notice 59) 30, 135


Presidentially declared disaster:Or combat zone, postponement of certain acts (RP 56) 34, 388Time for filing return (RR 59) 37, 582

Private foundations, organizations now classified as (Ann 67) 32,345

Proposed Regulations:26 CFR 1.42–10, –12, amended; section 42 utility allowance

regulations update (REG–128274–03) 33, 35626 CFR 1.42–18, added; section 42 qualified contract provi-

sions (REG–114084–04) 33, 35926 CFR 1.61–21, amended; 1.274–9, –10, added; de-

ductions for entertainment use of business aircraft(REG–147171–05) 32, 334

INCOME TAX—Cont.26 CFR 1.67–4, added; section 67 limitations on estates or

trusts (REG–128224–06) 36, 55126 CFR 1.165–5, amended; losses for abandoned stock or

securities (REG–101001–05) 36, 54826 CFR 1.199–3, –7, –8, amended; qualified films under sec-

tion 199 (REG–103842–07) 28, 79; correction (Ann 77) 38,662

26 CFR 1.382–7, added; built-in gains and losses under sec-tion 382(h) (REG–144540–06) 31, 296

26 CFR 1.817–5, amended; diversification requirements forvariable annuity, endowment, and life insurance contracts(REG–118719–07) 37, 593

26 CFR 1.883–0 thru –5, amended; exclusions from grossincome of foreign corporations (REG–138707–06) 32, 342

26 CFR 1.1397E–1, amended; qualified zone academybonds, obligations of states and political subdivisions(REG–121475–03) 35, 474

26 CFR 1.1502–13, –32, –35, –36, revised; unified rule forloss on subsidiary stock, correction to REG–157711–02(Ann 74) 35, 483

26 CFR 1.6411–2, –3, revised; clarification to section 6411regulations (REG–118886–06) 37, 591

26 CFR 31.3406(g)–1(f), amended; 301.6724–1, amended;information reporting and backup withholding for paymentcard transactions (REG–163195–05) 33, 366


26 CFR 301.6404–0, amended; 301.6404–4, added; applica-tion of section 6404(g) of the Code suspension provisions(REG–149036–04) 33, 365; (REG–149036–04) 34, 411

Publications:1141, General Rules and Specifications for Substitute Forms

W-2 and W-3, revised (RP 43) 27, 261179, General Rules and Specifications for Substitute Forms

1096, 1098, 1099, 5498, W-2G, and 1042-S, update (RP50) 31, 244

1220, Specifications for Filing Forms 1098, 1099, 5498 andW-2G Electronically or Magnetically, 2007 revision (RP51) 30, 143

4436, General Rules and Specifications for Substitute Form941 and Schedule B (Form 941), revised (RP 42) 27, 15

Qualified films under section 199 (REG–103842–07) 28, 79; cor-rection (Ann 77) 38, 662

Qualified Payment Card Agent (QPCA), payment card transac-tions (REG–163195–05) 33, 366

Qualified zone academy bonds, obligations of states and politicalsubdivisions (TD 9339) 35, 437; (REG–121475–03) 35, 474

Regulations:26 CFR 1.56–0, amended; 1.56–1(e)(4), revised; 1.6154–1

thru –5, removed; 1.6425–2(a), revised; 1.6425–3,amended; 1.6655–0, –4, –5, –6, added; 1.6655–1, –2,–3, revised; 1.6655–7, removed; 1.6655–5 redesignated as1.6655–7; new 1.6655–7, revised; 301.6154–1, removed;

September 24, 2007 ix 2007–39 I.R.B.

INCOME TAX—Cont.301.6655–1, revised; 602.101, amended; corporate esti-mated tax (TD 9347) 38, 624

26 CFR 1.125–2T, removed; employee benefits – cafeteriaplans (TD 9349) 39, 668

26 CFR 1.302–2, –4, amended; 1.302–2T, –4T, removed;1.331–1, amended; 1.331–1T, removed; 1.332–6, added;1.322–6T, removed; 1.338–0, –10, amended; 1.338–10T,removed; 1.351–3, added; 1.351–3T, removed; 1.355–0,amended; 1.355–5, added; 1.355–5T, removed; 1.368–3,added; 1.368–3T, removed; 1.381(b)–1, amended;1.381(b)–1T, removed; 1.382–1, –8, amended; 1.382–8T,–11T, removed; 1.382–11, added; 1.1081–11, added;1.1081–11T, removed; 1.1221–2, amended; 1.1221–2T,removed; 1.1502–13, –31, –32, –33, –90, –95, amended;1.1502–13T, –31T, –32T, –33T, –95T, removed; 1.1563–3,amended; 1.1563–3T, removed; 1.6012–2, amended;1.6012–2T, removed; guidance necessary to facilitate busi-ness electronic filing and burden reduction (TD 9329) 32,312

26 CFR 1.367(b)–2, amended; 1.367(b)–4(d), revised;1.1248–1, –2, –3, –7, revised; 1.1248–8, added; section1248 attribution principles (TD 9345) 36, 523

26 CFR 1.382–7T, added; built-in gains and losses under sec-tion 382(h) (TD 9330) 31, 239; correction (Ann 80) 38, 667

26 CFR 1.402(b)–1, amended; 1.402(g)(3)–1, added;1.402A–1, revised; 1.403(b)–0, added; 1.403(b)–1, –2,–3, revised; 1.403(b)–4 thru –11, added; 1.403(d)–1,removed; 1.414(c)–5 redesignated as 1.414(c)–6; new1.414(c)–5, added; 602.101, amended; revised regulationsconcerning section 403(b) tax-sheltered annuity contracts(TD 9340) 36, 487

26 CFR 1.475–0, amended; 1.475(a)–4, added; 1.475(e)–1,redesignated as 1.475(g)–1; 1.475(g)–1, amended;602.101, amended; safe harbor for valuation under section475 (TD 9328) 27, 1

26 CFR 1.883–0, thru –5, amended; 1.883–0T thru –5T,added; 602.101, amended; exclusions from gross incomeof foreign corporations (TD 9332) 32, 300

26 CFR 1.954–2, amended; 1.954–2T, removed; guidance un-der subpart F relating to partnerships (TD 9326) 31, 242

26 CFR 1.1397E–1, amended; 1.1397E–1T, added; 602.101,amended; qualified zone academy bonds, obligations ofstates and political subdivisions (TD 9339) 35, 437

26 CFR 1.1502–19, –80, amended; 1.1502–19T, –80T, re-moved; treatment of excess loss accounts (TD 9341) 35,449

26 CFR 1.1502–47, –76, amended; 1.1502–47T, –76T, re-moved; amendment of tacking rule requirements of life-nonlife consolidated regulations (TD 9342) 35, 451

26 CFR 1.1502–77, amended; 1.1502–77T, removed; agentfor a consolidated group with foreign common parent (TD9343) 36, 533

26 CFR 1.6011–4, revised; 1.6011–4T, removed; 20.6011–4,revised; 25.6011–4, revised; 31.6011–4, revised;53.6011–4, revised; 54.6011–4, revised; 56.6011–4,

INCOME TAX—Cont.revised; AJCA modifications to the section 6011 regula-tions (TD 9350) 38, 607

26 CFR 1.6012–2, amended; return required by subchapter Tcooperatives under section 6012 (TD 9336) 35, 461

26 CFR 1.6038–2, amended; 1.6038–2T, revised; 1.6038A–2,amended; information returns required with respect to cer-tain foreign corporations and certain foreign-owned domes-tic corporations (TD 9338) 35, 463

26 CFR 1.6411–2, –3, amended; 1.6411–2T, –3T, added; clar-ification of section 6411 regulations (TD 9355) 37, 577

26 CFR 301.6103(n)–1, revised; disclosure of returns and re-turn information in connection with written contracts oragreements for the acquisition of property or services fortax administration purposes (TD 9327) 28, 50

26 CFR 301.6111–3, added; 301.6111–3T, removed; AJCAmodifications to the section 6111 regulations (TD 9351) 38,616

26 CFR 301.6112–1, revised; AJCA modifications to the sec-tion 6112 regulations (TD 9352) 38, 621


26 CFR 301.6404–0T, –4T, added; application of section6404(g) of the Code suspension provisions (TD 9333) 33,350

Research agreements, private business use (RP 47) 29, 108Revenue rulings, RR 75–425 obsolete (RR 60) 38, 606Revocations, exempt organizations (Ann 64) 29, 125; (Ann 65)

30, 236; (Ann 69) 33, 371; (Ann 73) 34, 435; (Ann 76) 36,560; (Ann 86) 39, 719

Safe harbor for valuation under section 475 for dealers in secu-rities and commodities (TD 9328) 27, 1

Stocks:Attribution of earnings and profits to stock of controlled for-

eign corporations (TD 9345) 36, 523Post-grant restrictions added to previously vested stock (RR

49) 31, 237Standard Industry Fare Level (SIFL) formula (RR 55) 38, 604Subchapter T cooperatives, return required under section 6012

(TD 9336) 35, 461Substitute forms:

W-2 and W-3, general rules and specifications (RP 43) 27, 26941 and Schedule B (Form 941), general rules and specifica-

tions (RP 42) 27, 151096, 1098, 1099, 5498, W-2G, and 1042-S, rules and speci-

fications (RP 50) 31, 244Suspension of tax-exempt status of organizations identified with

terrorism (Ann 70) 33, 371Of tax-exempt status of organizations identified with terror-

ism (Ann 70) 33, 371Tax avoidance transaction involving foreign currency options

(Notice 71) 35, 472

2007–39 I.R.B. x September 24, 2007

INCOME TAX—Cont.Tax conventions, U.S.-Netherlands, qualification of certain pen-

sion and other employee benefit arrangements (Ann 75) 36,540


Tentative allowance of refund (RR 53) 37, 577Tentative carryback adjustment under section 6411, clarification

relating to the computation and allowance (TD 9355) 37, 577;(REG–118886–06) 37, 591

Transaction of interest:Contribution of successor member interest (Notice 72) 36,

544Identification of toggling grantor trust (Notice 73) 36, 545

Treatment of excess loss accounts (TD 9341) 35, 449

SELF-EMPLOYMENT TAXLiens, changes to office to which notices of nonjudicial sale and




Regulations:26 CFR 301.6343–2, amended; 301.6343–2T, added;

301.7425–3, amended; 301.7425–3T, added; changesto office to which notices of nonjudicial sale and requestsfor return of wrongfully levied property must be sent (TD9344) 36, 535

September 24, 2007 xi 2007–39 I.R.B.

2007–39 I.R.B. September 24, 2007

September 24, 2007 2007–39 I.R.B.

INTERNAL REVENUE BULLETINThe Introduction at the beginning of this issue describes the purpose and content of this publication. The weekly Internal Revenue

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Internal Revenue ServiceWashington, DC 20224Official BusinessPenalty for Private Use, $300