The IRS recently released an information letter addressing the treatment of cafeteria plan forfeitures when an employer ceases operations and the plan terminates. Specifically, the letter clarifies that Section 125 of the Internal Revenue Code does not require that unused cafeteria plan funds be paid to the U.S. Treasury in these circumstances. How unused funds are disposed of when a plan terminates depends on what the plan document provides and the facts and circumstances at the time.
In the case of ongoing cafeteria plans, Section 125 allows employers to retain forfeited funds, use the forfeitures to defray plan expenses or allocate the forfeitures among participants on a reasonable and uniform basis--based on contributions, for example, but not based on claims experience. Section 125 does not, however, permit employers to return forfeitures to plan participants in the amounts that the given participants forfeited or to reimburse former employees for health care expenses incurred after termination of employment (unless COBRA is elected).
Although this information letter has no official precedential value and does not contain any surprises or break new ground, it is still useful insofar as it serves to illuminate and reinforce the IRS’ views on appropriate plan operating rules and plan decisions regarding forfeitures.
Employers concerned about excessive forfeitures at the end of the plan year can implement plan design features, such as “rollover” and “grace period,” to provide participants with a longer timeframe in which to use their cafeteria plan funds and thereby reduce the likelihood that plan funds will be forfeited.