Cash in Lieu of Benefits | CA Employee Benefits

Jody Lee, Compliance Manager, Johnson & Dugan
Many employees are in a position to choose between their employer’s plan and another program where they meet the eligibility requirements (i.e. spouse’s plan). A Cash in Lieu of Benefits program, or cash-out option, offers an incentive for those employees to waive the employer coverage and instead enroll in the other plan. The incentive is in the form of a cash payment added to their paycheck.

Properly implementing a Cash in Lieu of Benefits program is crucial, as unexpected tax consequences could occur otherwise. A 1994 Internal Revenue Service (IRS) technical advice memorandum (TAM 9406002) [attached below for your reference] advises that a Section 125 plan must be in place in order to be a qualified cash-out option. If the plan is not set up under an IRC Section 125 plan, employees who elect coverage under the health plan will be taxed on an amount equal to the amount of cash they could have received for waiving coverage.
Using Revenue Ruling 74-32 as precedent, the IRS has ruled that when an option is available to either elect the health plan, or to receive a cash-out incentive, then the premium payment to the insurance company becomes wages. Here is the justification: “If a prospective employee contracts to have Taxpayer pay amounts to the insurance company where the employee has the option of receiving those amounts as wages, the employee is merely assigning future income (cash compensation) for consideration (accident health insurance coverage) and thus, is treated as receiving the cash compensation for which the accident and health insurance coverage is a mere substitute. It is as if the entire compensation for services had been paid directly to the employee and then a portion paid over by the employee as his or her contribution to payment of the accident and health insurance premiums.”
By setting up an IRC Section 125 plan, the employer is offering a choice between cash and certain excludable employer-provided benefits. By virtue of its design, a Section 125 plan can offer a choice of benefits, including cash, without the above-mentioned tax implications.
To be a qualified Section 125 plan, nondiscrimination requirements must be included and there must be a Plan Document in place. When a Section 125 plan already exists (Premium Payment Plan, Health Care Spending Account, Dependent Care Spending Account), then an amendment to the plan will be sufficient. Either your plan administrator or an ERISA attorney can assist. Where no Section 125 plan is in place, it is standard to have an attorney provide this service.
It is important to note that, although the Section 125 plan protects the employees electing coverage from taxation, the cash-out incentive is an after-tax benefit.
Another thing to consider when setting up a cash-out incentive plan is proper documentation. An employee should only be allowed to waive coverage when there is another plan available and proof of enrollment is provided. If there is a subsequent loss of that coverage, HIPAA Special Enrollment Rights will allow entry onto the plan, and the cash-out incentive will cease.
For further information on this topic, please contact your Johnson & Dugan team.
Download TAM9406002.pdf
[originally posted July 8, 2005]