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An examination of the factors affecting the choice of employee fringe benefits and cafeteria plans

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Title:
An examination of the factors affecting the choice of employee fringe benefits and cafeteria plans
Creator:
Olson, Carol Ann Felicia, 1947-
Publication Date:
Language:
English
Physical Description:
ix, 174 leaves : ill. ; 28 cm.

Subjects

Subjects / Keywords:
Business executives ( jstor )
Cafeteria plans ( jstor )
Cafeterias ( jstor )
Cash ( jstor )
Employee benefits ( jstor )
Employee compensation ( jstor )
Employees ( jstor )
Family size ( jstor )
Life insurance ( jstor )
Taxes ( jstor )
Accounting thesis Ph. D
Cafeteria benefit plans -- Florida ( lcsh )
Choice (Psychology) ( lcsh )
Dissertations, Academic -- Accounting -- UF
Employee fringe benefits -- Florida ( lcsh )

Notes

Thesis:
Thesis (Ph. D.)--University of Florida, 1989.
Bibliography:
Includes bibliographical references (leaves 168-173)
General Note:
Typescript.
General Note:
Vita.
Statement of Responsibility:
by Carol Ann Felicia Olson.

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University of Florida
Holding Location:
University of Florida
Rights Management:
Copyright [name of dissertation author]. Permission granted to the University of Florida to digitize, archive and distribute this item for non-profit research and educational purposes. Any reuse of this item in excess of fair use or other copyright exemptions requires permission of the copyright holder.
Resource Identifier:
001482519 ( ALEPH )
21018782 ( OCLC )
AGZ4533 ( NOTIS )

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AN EXAMINATION OF THE FACTORS AFFECTING THE CHOICE OF
EMPLOYEE FRINGE BENEFITS AND CAFETERIA PLANS
















BY

CAROL ANN FELICIA OLSON


A DISSERTATION PRESENTED TO THE GRADUATE SCHOOL
OF THE UNIVERSITY OF FLORIDA IN PARTIAL FULFILLMENT














ACKNOWLEDGMENTS


I wish to express my appreciation to John L. Kramer, dissertation

committee chairman, for his comments, suggestions, editorial assistance,

and guidance in the completion of this study.

The members of my dissertation committee namely, Professors Bipin


B. Ajinkya, Dennis A. Calfee, and Sandra


Kramer, freely shared their


time and expertise to


assist me in completing this project


Comments and


suggestions from the Ph.D. students and faculty at the University of


Florida Accounting Workshop were al


helpful


Robert E. Chapman, President and Chief Executive Officer of

Chapman Contracting Company, graciously shared his time and resources to


assist me in completing thi


project.


Finally, I wish to express my appreciation to my husband, Law-


rence H. Olson, my daughter, Kathryn


01son, and my family and friends


for their encouragement, patience, and support that made completion of

this project possible.















TABLE OF CONTENTS


Page


ACKNOWLEDGMENTS.................................... ......... .

LIST OF TABLES..............................................

LIST OF FIGURES..............................................


Viii


CHAPTER


INTRODUCTION.....


Statement of the Problem....
Research Methodology........
Research Questions........
Data and the Questionnaire
Statistical Tests........
Related Research............
Contributions of This Study.
Limitations.................
Summary of Chapter Contents.
Notes.......................


TAX TREATMENT OF FRINGE BENEFITS.


Fringe Benefit Movement...........
Nontaxable Fringe Benefits.........
Section 79--Group-Term Life Insur
Section 101(b)--Employees' Death
Section 105(b)--Accident and Heal
Section 105(h)--Self-Insured Medi
Reimbursement Plans...........
Section 106--Employer Contributio
Accident and Health Plans......


Section
Sectinn


"ance........
Benefits....
th Plans....
cal Expense

)ns for
. ...........


119--Meals and Lodging...................
12--nualified Grouon Leaal Services Plans


ABSTRACT. ........................................










Page
Deferred Compensation Plans............................ 53
Qualified Deferred Compensation Plans................ 53
Salary Reduction Plans............................... 54
Nonqualified Deferred Compensation Plans............. 55
Stock Options............................. ... .. 55
Notes.................................................. 56

3 CAFETERIA PLANS........................................ 60

Cafeteria Plan Features................................ 6()
Consequences to Management of Cafeteria Plans........ 61
Consequences to Employees of Cafeteria Plans......... 62
Types of Cafeteria Plans............................. 64
Legislative History of the Taxation of
Cafeteria Plans......................................... 65
Taxation of Cafeteria Plans............................ 69
The Cafeteria Plan................................... 69
Definition of Nontaxable Benefits.................... 71
Nondiscrimination Standards.......... ................ 72
Taxation of Discrininatory Plans..................... 74
Recordkeepi ng Requi rements........................... 74
Transitional Rules for Compliance.................... 75
Notes.................. ............................. 76

4 RESEARCH METHODOLOGY................................... 79

The Ouestionnaire...................................... 79
Research Question One................................. 84
Treatment Variables.................................. 85
Dependent Variables................................. 86
Statistical Procedure................................ 88
Research Hypothesis.................................... 91
Research Question Two......................... ........ 92
Treatment Vari abl es......... ........................ 92
Dependent Variables.................................. 92
Statistical Procedure.............................. 93
Research Hypothesis ...... ........................... 95
Research Question Three................................ 96
Treatment Variables.................................. 97
Dependent Variables...................... ... .. ..... .. 98
Statistical Procedure.. ...... ...... ............ 98
Research Hypothesis..... ..... ........................ 99
Notes.......................... ........................ 100










Page


Research Question Three...
Years of Service Factor.
Job Class Factor.......
Management Factor.......
Family Size Factor......
Analysis of Results.......
Research Question One...
Research Question Two...
Research Question Three.
Notes........... ..... .


6 SUMMARY AND CONCLUSIONS ................................


Summary and Conclusions........
Historical Background........
Research Design..............
Empirical Results............
Recommendations............
Limitations of the Study.......
Suggestions for Future Research
Note...........................


APPENDICES


A SAMPLE OUESTIONNAIRE ....... ......... .................

B AHP RATING SCALE..........................

C CAFETERIA PLAN BENEFITS.............. ..................

D SAMPLE CAFETERIA PLANS...............................

E EMPLOYEE PROFILES.............,........................

BIBLIOGRAPHY.................................................

BIOGRAPHICAL SKETCH..........................................















LIST OF TABLES


Page


Manova Table For Treatment Variables....................

Anova Results For the Cell Means of Costs


and Status..........


Anova Results For the Cell Means of Tax and


Financial Security.....


Anova Summary of Means For Costs, Status, Tax,
and Financial Security................


Manova Table For Treatment Variabl


es....................


Anova Results For the Cell Means of Life and Health.....

Anova Results For the Cell Means of Legal
and Dependent......................................


Anova Results For the Cell Means of Retirement
and Cash.....................................

Anova Summary of Means For Life, Health, Legal,
Dependent, Retirement, and Cash..............

Chi-Square Test For Independence of Plan Choice


by Years of


Chi-Square Test For Independence of Plan Choice


by Job C1


Chi-Square Test For Independence of Plan Choice


by Family


Plan Choice by Firm--Years of Service--Job Class--


Management--Family


Service.


Size...................


Si ze. .. ..........















LIST OF FIGURES


Page


AHP Hierarchy For Research Questions One and Two........

Two-Level Hierarchy For Research Question Three.........

Anova Summary of Means For Tax and Financial


Security by


Anova Summary of Means For Costs, Status, Tax,
and Financial Security by Job Class..................

Anova Summnary of Means For Life, Health, Legal,
Dependent, Retiremlent, and Cash by Job Class..........

Anova Summary of Means For Life, Health, Legal,
Dependent, Retirement, and Cash by Age...............

Anova Summnary of Means For Life, Health, Legal,


Dependent, Retirement, and Cash by Family


Size........


Ay e .















Abstract of Dissertation Presented to the Graduate School
of the University of Florida in Partial Fulfillment of the
Requirements for the Degree of Doctor of Philosophy

AN EXAMINATION OF THE FACTORS AFFECTING THE CHOICE OF
EMPLOYEE FRINGE BENEFITS AND CAFETERIA PLANS

By

Carol Ann Felicia Olson


May, 1989


Chairman:


John L. Kramer


Major Department:


Accounting


Noncash compensation, in the form of fringe benefits, has been


increasing over the years.


In administering these fringe benefits, one


approach that a firm may use is a "cafeteria plan" where employees buy


the fringe benefits that they need.


The cafeteria plan approach has been


advocated by management theorists since the early sixties.


Preferential


tax treatment for cafeteria plans was enacted by Congress in the Revenue

Act of 1978.

This study investigated the motives of employees in choosing


fringe benefits, the actual fringe benefit


choices made by emp


oyees,


whether the motives


and choices of empl


oyees


surveyed differed because of


empl


oyee


ass,


age, and family


size.


This study investigated fur-


other whether empl


oyees


would choose a cafeteria plan and


would









The motivational factors included in the study were cost say-


ings, status among peers, tax savings, and financial security. The

findings indicated that employees in all job classes, other than the

executives, all age groups, and all family size groups ranked the factors

in the following descending order: financial security, cost savings, tax


savings, and status among peers.


The executives ranked the tax savings


factor higher than the cost savings factor.

The fringe benefits included in the study were group-term life

insurance, health insurance, legal services, dependent care services,


retirement, and cash.


asses,


The findings indicated that employees in all job


age groups, and family size groups ranked the fringe benefits


in the following descending order: retirement, health insurance, cash,


and group-term life insurance.


The rank of the legal services benefit


and the dependent care benefit varied by job


lass, age, and family


size.


The cafeteria plans included in the study were a core plan,


a mini-plan


and a full choice plan.


The findings indicated that the


choice of plan was finn specific.


plan was desired.


For most finns, some sort of cafeteria


The factor of family size was the controlling vari-


able.














CHAPTER 1
INTRODUCTION


Noncash compensation in the pay packages of the U.S. work force


is increasing


. Fringe benefit


such


as health and life insurance, pen-


sions, and other agreed upon items, comprised 9.6 percent of 1965 gross


payroll.1


By 1985, these and similar benefit


comprised


37.7%


of gross


payro

(


11l


Woodbury cites seven factors underlying this phenomenon:


1) preferential treatment under federal personal income tax
aws ; (2) savings that are made possible by group purchase


of some benefits


, notably insurance; (3) efforts to reduce turnover


in the face of rising costs to labor turnover


tion.


; (4) union


. (5) preferential treatment under federal corporate income


tax laws; (6) the changing age composition of the
(7) the effect of rising incomes.4


The ri


abor force; and


in health care costs over the years is also a contributing fac-


tor.5


Usually


the firm cho


oses


the benefit offerings based on the


"average" employee needs and preferences.


Some firms provide additional


benefit


only to targeted employee groups.6


While there appears to be


some fl


exibility in these arrangements, the firm may be spending company


dollars on benefits that may have litti


empl


or no value to the individual


oyees.


Since the early sixties


management theorists have advocated a


concept called the "cafeteria plan."









In essence, the employee takes a fixed percentage of compensation and


spends it on benefits versus taking it in cash.


The advantages of this


arrangement accrue to the employees in the form of benefit

cording to their needs and economies of group purchasing.


hand, management explicitly enjoys a cost savings becau


payments are not subject to payroll taxes and, al


selection


On the other

these in-kind


may not enter into


the payroll base for insurance purposes (e.g., workmen's compensation).


Implicitly, management may al


gain in improved employee relations and


productivity.


To encourage this type of mutual arrangement


Code Section 125 on Cafeteria Plans


Congress enacted


as part of the 1978 Revenue Act8


allowing the employee to freely choose between taxable and nontaxab


fringe benefits without additional tax ramifications.


Code Section 125


was retained and revised in the Tax Reform Act of 1984 (TRA 84).9


visions were made to curb abuses in existing cafeteria plans


as well


to use these plans to assist in health cost containment studies.10


Clearly, Congress intended to continue this favorable


tax provision.


With tax incentives offered to both employer and employee since


1978, we would have expected to


see a rl


in the adoption of cafeteria


plans among firms.

cafeteria plans.11


Ry 1984, only about 400 firms nationwide had adopted

The slow growth of this concept has been attributed


to the ambiguity of the tax laws in this area.12


The passage of the TRA


84 has, to some extent, clarified this particular problem.


However









demand) fringe benefits for employees.


Management (unions)


selects


fringe benefit offerings based on the marginal (median) worker prefer-


ences.


Further, the supply and demand for fringe benefits is largely


thought to exist mainly because of tax advantages to both part


Prior


research,14 however, has shown that employee preferences for life and

health insurance benefits are not based solely on tax considerations.

And, employees are generally not aware of the cost or value of fringe

benefits that they receive.15

In excluding certain fringe benefits from taxation, the intent of

Congress was to foster social policy in terms of making necessary goods


services


more readily availabi


to the general employee.16


In 1983,


John Chapoton, Assistant Treasury Secretary for Tax Policy, warned that

sufficient study had not been given to the cafeteria plan concept.17 I

early 1984, the IRS attacked "flexible spending" and "Zebra" cafeteria-

type plans on the basis that these were salary reduction plans that al-


lowed the employee more tax-free benefit


than were authorized by the


1978


legislation.


In 1984, Chapoton applauded the government for its


crackdown on cafeteria plans in the TRA 84 but still was dissatisfied

that these plans would cost the government $7 billion dollars in general

revenue receipts and $3.2 billion dollars in Social Security receipts


during 1984 through 1989.


In addition, Chapoton maintained that cafe-


teria plans would not be effective in containing health care


costs.


Between 1983 and 1984, benefits analysts and employers agreed









"flexible


plan ru


spending" and "Zebra" plans


as opposed to the strict cafeteria


because these former plans were better ab


to address the


adverse


costs .20


section problem that has contributed to rising health care


Edward Davey, executive director and general counsel of the


Association of Private Pension and Welfare Plans, succinctly summed up


the private


sector's views of Congress


efforts in the area of fringe


benefits with the following statement.


Most of the changes to Internal Revenue Code provi


ons affecting


fringe benefits are based on sketchy and incomplete data, if based on


fact at all,


programs


as efficiently


It is the private sector that has provided the


most comprehensive employee benefit package available


to employees


. and there is no evidence that the government could run these


that the government would be prepared to assume the costs attendant
to doing so.21


Statement of the Problem


as they are run in the private sector, or


In light of the controversy surrounding the objectives of fringe


benefit legislation


this study investigates the employee-taxpayer moti-


vations for choosing


certain fringe benefits


the actua


mix of fringe


benefits desired, and the appeal of the cafeteria plan concept to the em-

ployee.


First, a determination will be made of the factors that motivate


oyees


select certain fringe benefits.


In choosing from a wide


menu of benefits, many demographic variables such as age, marital status,

etc., may interact with the tax savings factor or other economic factors


to alter the anployee


preference orderings.


question


should be










then the tax system may be an inappropriate vehicle


social


for achieving certain


objectives.


(fbronl. *in invosti iatil wi i l he I aI(tPh to assess tlhe ) rofr'it'ces


of a wide range of employees in choosing actual taxable and nontaxabi


fringe benefits


The results of such an effort may be important to man-


agement by knowing the nature and extent of basic relationships existing

between certain employee groups and their needs.


Third, an anal


ysis


of cafeteria plan choice among empi


oyees


will


be undertaken.


To date, no study has empirically investigated whether


the cafeteria plan concept is acceptable


to employees or not.


There may


be a broad spectrum of plans, each qualifying under the federal income


tax 1


as a true flexible


cafeteria approach, that can be created.


Several main configurations can be identified.


Management, in the course


of adopting a cafeteria plan and communicating this plan to the employee,

may benefit by understanding the tradeoff that the employee makes between

security and flexibility in choosing a compensation package.


Research Methodology


This study will utilize a priority-theory-based questionnaire to

gather responses to three research questions from individuals in a wide


range of employee classifications.


Research Question One


assesses


fac-


tors motivating employee selection of fringe benefits.


Research Question


assesses


nten etlnn Thu-na


employee preferences for fringe benefit mixes.


The rac at


LIjr.~ I.. aIFl* I I. lf fl '''C rT


Research


pmnnlnvP nrpfprpncrp fnr rafptpria nlan depians.


I.










Research Question One.


Does a significant difference exist in


the ranking of choi


variabi


(cost savings, economic status, tax


savings, financial security) among empl


oyees


strati field


as to job


ass,


age, and family si


Job class is used as a surrogate for employee income.


Age is


measured


as the chronological age of the employee.


Family


si ze


distin-


guishes employees on the basis of being a single


with nonchild dependent


taxpayer with nonchild and

The choice variabi


taxpayer, a taxpayer


, a taxpayer with only child dependents, and a


hild dependents.

employed here are limited to cost savings


(representing economies of


scal


and the increased availability of


cer-


tain fringe benefits), economic status (representing peer pressure to


acquire certain fringe benefits)


tax savings


representing tax incen-


tives


and financial security (representing financial peace of mind).


Research Question Two.


Does a significant difference exist in


the ranking of six fringe benefits (group-term life insurance, group


health


insurance, group


egal services, dependent care services,


certain retirement plans, and cash bonuses) among the empi


oyees


surveyed?

The employees will be stratified according to job class, age, and


farmi ly


size.


The job class, age, and family


size


variables are defined


the same


as in Research Question One.


The six fringe benefits selected


in the study are only those that may be selected by empl


oyees


within a









(a) years of service; (b) job


ass;


(c) family


size;


(d) position


within the firm?

Research Question Three attempts to determine whether there is a


significant difference between employees with respect to


certain type of cafeteria plan


ecting a


as opposed to remaining with their current


compensation plan.


The years-of-service variable is defined


as the years


of employment with the current firm.


are defined the same


The job class and family


as in Research Question One.


si ze


The empl


Va r-


oyee' s


position within the finn is defined as being


classified


as either execu-


tive/management or all others.

The three cafeteria plans that will be compared with the em-

ployee's status quo are structured to represent partial flexibility with

no employee choice, partial flexibility with employee choice, and full


flexibility with employee


choice.


Data and the Questionnaire


Over 400 employees from a total of seven finns in the construc-

tion and service industries in the state of Florida were selected to


participate in this study.


Appendix E, EMPLOYEE PROFILES.)


None of


the firms were unionized.


None of the firms had a cafeteria plan in


place at the time of the study.

For all three research questions, the design of the questionnaire


was of paramount importance.


The objective was to solicit responses from


emol


o vees


that could establish their revealed preferences for fringe hen-


J









the human mind works in solving a problem that entail


many factors and


involves choosing the best solution from among several viabh


alterna-


tives.


The process reveal


an ultimate solution


as well


as a preference


ordering for all of the viabi


alternatives.


A large body of demographic data on each employee (i.e., age,

marital status, number of dependents, occupation of spouse, spouse's


fringe benefits


analysis


of the r


etc.) was also collected to assist in the accurate

results.


Statistical Tests


To test the validity of Research Question One


procedure of MANOVA was employed.


the statistical


MANOVA was used at the outset because


a vector of responses, the preference ordering of four "choice" var-


es, was solicited rather than a single choice variable


Also, the


design matrix consisted of three treatment variables: five 1


evel


of the


job cl


factor (JC), five level


of the age group factor


A), and four


leve


of the family si


factor (FS)


The model employed i


Ycijkm


= Uc + JCci + Acj + FSck + (JCcAc)ij + (JCcFSc)ik


+ (AcFSc)jk + (JCcAcFSc)ijk + Ecijkm, where


= 1,...,4;


,...,


= 1.,


= 1,...,4


,...,nijk,


where


Ycij km


the proportion of priority


individual in


cell ijk for the


assigned by the m-th
c-th choice var-


iable;

are the parameters for the c-th choice variabi


iCr-i


is the effect of the job class factor level for


..,5










(JCcAc)ij


JCcFSc)ik


is the two-way interaction effect between the job
class factor and the age group factor for the c-th
choice variable:


is the two-way interaction effect between the job


class factor and the family
c-th choice variable;


si ze


factor for the


AcFSc)j k


is the two-way interaction effect between the age


group factor and the family
c-th choice variable:


size


factor for the


(JCcAcFSc)ijk


is the three-way interaction effect between the job


class


si ze


factor, the age group factor, and the family
factor for the c-th choice variable: and


Ecijkm


are the vector random variable


terms.


Research Question One i


tested for any three-way interaction,


any two-way interactions, and for any main effects when the four choice


variables are considered simultaneously.


Also, it i


reasonable


to per-


form a three-factor ANOVA on each of the individual dependent variables


since the choice variabi


are measured such that they denote relative


weights applied to the four "choice" dimensions.


To test Research Question Two, the same basic model is used


cept that the "c" subscript is now replaced by the "f" subscript, denot-


ing a change in the number and type of response variable


from


= choice variabi


to f


= fringe benefits).


The model i


stated


Yfij kmi


= Uf + JCfi + Afj + FSfk + (JCfAf)ij + (JCfFSf)ik


+ (AfFSf)jk + (JCfAfFSf)ijk + Efijkm, where f


= 1,...,6;


s...


-= 1,


nijk.


The same test procedures and analysis of results are also employed.


=1,.,


= ),


.e












j=1


where


= row categories of the first criterion;


= column categories of the second criterion;


= the observed frequenci


= the expected frequency


in cell


in cell


Research Question


Three invol


four different designs:


a 6X4 design


ix groups of the "years of service" treatment X


years-of-service factor;


four plans)


a 5X4 design (five groups of the


to anal


"job


treatment X


four plans)


to analyze


the job class factor; a 4X4 d


(four groups of the "family


ze" treatment X


four plans) to anal


family


size


factor;


and a


X4 design


two groups of the "employee v


management" treatment X


four plans)


to analyze the employment position


factor


Related Research25


Prior to the Revenue Act of 1978, over


150 arti


were written


about cafeteria compensation.


It was a flourishing topic for argument


with


little in the way of research to establish employee


benefit or plan


preferences.


Article


of the type by Mullin discussed,


in general,


pros and cons of cafeteria plans with respect to executive pay pack-


ages.


Hettenhouse proposed a cafeteria plan design but that


too, was


targeted for executives.


Goode reported on a survey, conducted by his


onsultina firm. of State of California emolovees.


He concluded that


i=r
i=l


iJEj )2
E-


: and


Y









successful


plans and generally discussed how the merits of the cafeteria


concept outweighed the disadvantages.29


A full cafeteria approach, in-


corporating all levels of employee


asses,


was proposed by Thomsen.30


He outlined a systems approach to the formulation and implementation of a

comprehensive plan, including techniques for soliciting employee choices

of benefits and techniques for educating the employees.

Most of the research prior to the enactment of Code Section 125

was either descriptive (anecdotal evidence) or normative (the "how to"


approach).


The types of artici


written in this period could be viewed


from the perspective that the cafeteria concept was viabi


many firms had adopted thi


but that not


compensation form because of the volatility


in the fringe benefit and cafeteria plan taxation areas.

Since the enactment of Code Section 125, articles continued to

relate anecdotal evidence of firms experimenting with cafeteria plans.31


However, the trend seemed to imply that more firms were having


with these plans


success


discussed various plan configurations such as


"core," "buffet," and "alternative dinners" plans to show the extent to

which benefits could be offered to satisfy both management and employee


needs.


Velleman33 also described various plan configurations such as


a "mini-flex" and "mini-fl


plus," but the focus was more toward tax


law requirements and prohibitions.34

Of a more empirical nature, in 1979, Swad35 investigated whether

employees in manufacturing, trading, and service companies were motivated










participation in the firm through benefit offerings did have a positive

impact on the efficiency of operations.

Lassila constructed a framework for compensation packages with


respect to shareholders-employees of Subchapter


Corporations.36


model rank ordered four major compensation forms: (1) nontaxabi


fringe


benefits,


2) current


salary or bonus, (3) pension and profit


sharing


plans and (4


nonqualified deferred compensation (NQDC)


Noneconomic


variabi


and individual utility preferences were not considered


major findings were that (1) nontaxable fringe benefits ranked higher


than current


salary/bonus and NQDC, (2) current salary/bonus and NODC


ranked about the same, (3) pension and profit sharing plan rankings


depended on the rate of return of plan


rate of return on the employee


assets and the expected after-tax


personal investments, and (4) the need


to include nonshareholder employees in fringe benefit and qualified

pension and profit sharing plans could alter the structure of these


compensation arrangements.

solely on tax consequences


Since his study suggested a model based

, it only provided a normative solution to the


use of compensation alternati


under the


existing tax laws.


Woodbury, noting an increase toward a higher percentage of fringe


benefits in pay packages over the years, designed a mode


such variable


incorporating


as the price of fringe benefits, employee marginal tax


rates, unionization, age of employee, and firm


size


to determine the


effect of these variables on the waae-frinae mix.37


One set of data was









teachers in loca


school districts.


His conclusions were that (1) larger


establishments pay a higher proportion of total compensation in the form

of fringe benefits; (2) collective bargaining shifts the compensation mix

toward fringe benefits; (3) younger, lower-wage employees have a higher

proportion of total compensation in the form of fringe benefits than

older, higher-wage earners; (4) higher-income workers prefer others to


seek out and administer insurance and pension systems for them; and (5


there is an


ease


of substitution of wages for fringe benefits especially


when the fringe benefits include health insurance, life insurance, and


pension benefits moreso than just with health insurance and


ife insur-


ance benefits.

In an attempt to focus on the cafeteria plan concept, White con-

ducted a survey of 458 employees from four large firms, asking them to

divide a dollar amount of total compensation between cash and five fringe

benefits: health insurance, life insurance, education, retirement, and


legal.


To determine if the nontaxabi


aspect of fringes would affect


their cho

taxable.


i


ce, one-half of the subjects were told that the benefits were


the other half were told that the benefits were nontaxabi


determine whether differences existed among employees, all subjects were


stratified into four job classes: upper management, lower/middl


ment, professional, semi-skilled.


nanage-


The results of the study indicated


that (1) the tax incentive of fringe benefits was perceived to be signif-


icant in the


case


of only some fringe benefit


(2) only the education,









and (5) health, legal, and education fringe benefits were preferred by


lower job cl


asses


retirement benefits were preferred by higher job


asses.


In retrospect, prior research indicates three conclusions.

First, not enough information is available regarding the motivation of


employees in choosing fringe benefits.


Second, no data are available


regarding the possible interactions of employee age, job class, and


family


size


group that may account for the employee


ultimate choice of


fringe benefits.


Finally, no data are available concerning the employee's


acceptance of the cafeteria concept.


Contributions of This Study


The tax laws provide an incentive for employers and employees to


arrange compensation packages for their mutual benefit.

provide information regarding employee motivation in se


benefits and plan structures.


This study wil


electing fringe


The investigation focuses on the employee


as the "purchaser" of the fringe benefits rather than being the passive

"recipient" of benefits given by management.


The results of thi


study may well reflect that variable


other


than the tax savings variable may be the most important in the employee


choice of a fringe benefit.


Since Congress has altered the cafeteria


plan area significantly in order to curb excessive abuse of nontaxable

benefits, it may be important to note which fringe benefit or plan pref-


erences are common amona emol


ovees


in order to further modify the tax law







15


The results pertaining to the employees' acceptance of certain cafeteria

plans may make management aware of the tradeoff that exists between

security and flexibility in adopting certain cafeteria plan designs.

Communications between management and the employee may therefore be


enhanced.


Also, the methodology employed in this study with respect to


designing the research questionnaire may be an aid to management in


determining the needs and desires of their empi


oyees.


Limitations


This study investigates the motivation for and the fringe benefit


choi


of employees within the framework of a cafeteria plan design.


The firms participating in this research are from the construction and


serve


industries.


Therefore, the results of this study may be general-


ized only in that context


And, since none of the firms participating in


the study are unionized, the results may be generalized only to nonunion


firms.


Empl


oyees


governed by collectively-bargained compensation con-


tracts have 1


inhibition to reveal their motivational and actual


benefit preferences to the agent (union) rather than directly to the


adversary (management).39


To the extent that the subjects in the study


perceive that their anonymity will be guaranteed, their revealed prefer-


ences may be more natural.


This is not to imply, however, that the


subjects in the experiment will more closely resemble unionized workers.


The subjects


ected for study are from Florida-based firms.


The repnnnp






16

The study involves the use of a questionnaire based on the theory


of the AHP.


The use of pai rwise-comparisons (AHP) versus "game board"


techniques has proven to be equally consistent in measuring the subject's


responses.41


The subjects are


asked to make these AHP responses within a


fifty-minute time frame.


In reality, where the employee has to make a


decision concerning compensation, the time frame may extend several days


and may involve input from the spouse or other family members.


To this


extent, the results may be biased in that employees must make on-the-spot


decisions.


However, the decisions that are to be made are of a general


nature and do not involve intricate dollar amounts.


To minimi ze this


problem, demographic data will be collected from each subject to identify


his/her head of household status and to


identify other fringe benefits


accruing to the household.


Summary of Chapter Contents


This paper is organized in the following manner.


Chapter


Tax Treatment of Fringe Benefits.


A discussion of the


fringe benefit movement, the tax treatment accorded fringe benefits, and


an overview of


ected deferred compensation plans is presented.


Chapter 3--Cafeteria Plans.


A discussion of the general nature


and legislative history of the taxation of cafeteria plans is presented.


Chapter 4--Research Methodology.


A discussion of the data con-


cerning the AHP questionnaire, the formulation of hypotheses based upon


economic


theory, and the statistical tests employed is presented.









Chapter 6--Sunnary and Conclusions.


ground, purpose,


A synopsis of the back-


research methodology, and results of this study includ-


ing the conclusions and possibilities for future research is presented.


Notes


iness,


'J.S. Lublin,
, 1982, p. 1.

2J.R. Morris,
February 1987,


"Labor Letter," The Wall Street Journal


"Those Burgeoning Worker Benefits," Nation
0D. 53-54.


Novem-


Bus-


1986.


30ata gathered for this study were completed in the spring of
Therefore, all references to historical background, to prior re-


search in this area, and to the tax
present at that time.


aws reflect the conditions that were


4SCiUA


Woodbury,


"Substitution Between Wage and Nonwage Benefits,"


The American Economic Review 73 (March 1983): 167-68.


5See


C.E. Beadle,


"Lower Health Care Costs Through "Flexible"


Benefits," Financial Executive 51 (March 1983): 12-1


Mieher,


"Cafeteria Plans Let Workers Pick and Choose Health Benefits," St.
Petersburg Times, June 17, 1984, p. 7.


6Such practices are extremely popular in the area of
compensation by providing this group with such benefits as s
bonuses, and various forms of deferred compensation.


7D.L. Thomsen,


exec


utive


tock options,


"Introducing Cafeteria Compensation in Your Com-


pany," Personnel Journal 56 (March 1977)


: 124


UI.S., Congress, House, Revenue Act of 1978, Pub. L. 95-600,
95th Cong., 1978, Section 134(a).


9U
98th Cong.


.S.,


Congress, House, Tax Reform Act of 1984, Pub. L. 98-369,


, 1984, Section 531(b)


IuU.S., Congress, Joint Committee on Taxation
tee Report No. 98-861 on H.R. 4170, 98th Cong., 1984.


Conference Commit-
Congress sought


to curb abuses by limiting the types of benefits that may be offered in a


cafeteria plan (Section 531(b)(2)(A)).


Also, the average employee i


better protected by new nondiscrimination rules (Section 531(b)(3)). To









11"Cafeteria Laws and Rules Have Immediate Impact, But Demo-


graphic Forces Favor Flexibli
39 (January 1985): 8.

12E. Wojahn, "Beyond


Benefits," Employee Benefit Plan Review


I the Fringes," Inc., March 1984, pp. 61-66.


13See R.P. Hartmnan and R.A. White,


"Why Not Try a Cafeteria Bene-


fit Plan?"


, Management Accounting 66 (October 1984)


"Benefits, Buffet Style," Nation'


44-47


Business, January 1987, pp.


M. Allen,


45-47


14See R.G. Rice,


"Skill, Earnings, and the Growth of Wage Suppl


ments," American Economic Review 56 (May 1966): 583-93;


R.A. White,


"Employee Preferences for Nontaxabi


Compensation Offered in a Cafeteria


Compensation Plan: An Empirical Study," The Accounting Review
1983): 539-61.


15See R.B. Freeman,


(July


"The Effect of Unionism on Fringe Benefits,"


Industrial and Labor Relations Review 34 (July 1981)


489-509


Freeman


remarks that workers typically possess little knowledge of their fringe


benefit


He cites an advertisement in the February 6, 1980 Wall Street


Journal by the Prudential Insurance Company of America offering employers
the service of Prudential's Employer's Advisory Service in providing
workers with individualized statements of their fringe benefits.


16See "Statement by John E. Chapoton, Assistant Treasury


tary for Tax Policy, at Hearing June


Secre-


1983, by Senate Finance Commit-


tee and Joint Committee on Taxation Staff Pamphlet Giving Overview of
S640, Administration's Proposal to Cap Exclusion for Employer-Provided
Medical Care, and of Tax Treatment of Other Fringe Benefits, Considered


at Hearing," Daily Tax Report No. 121, June


1983, p. J-l


17Ibid., p. J-19.

18"Fringe Benefits


Labor, Business Groups Back Tax Incentives


Over Treasury Objections," Dail


p. G


Had proliferation of


been allowed, the total revenue 1


Tax Report No. 145, July 27, 1984,
exible spending" and "Zebra" accounts
oss would have been $20 billion dollars


over the same time period.

19"Fringe Benefits: Employers and Others Downplay Tax Policy,
Revenue Needs in Taxing Benefits," Daily Tax Report No. 146, July 30,


1984, p


G-l.


201bid.


, p. G-2.


21"Frinqe Benefits


Labor, Business Groups Back Tax Incentives


.









23Job class is a surrogate for income in this study in order to


compare the results of this study with prior studies.


The demographic


data requested in the questionnaire will include figures for employee


income and taxabi


income.


24For the basic theory and applications,


Se


Analytical Hierarchy Process (New York: McGraw-Hil


!e T.L. Saaty, The
, Inc., 1980).


25See


Note 3.


26p. W. Mullin, "A Ne
ning," Trusts and Estates 111


w Approach to E
(November 1972


executive Fringe Benefit Plan-
): 862-64.


276. W. Hettenhouse,


"Compensation Cafeteria for Top Executives,"


Harvard Business Review 49 (September-October 1971): 113-19.


. V. Goode,


"Complications at the Cafeteria Checkout Line,"


Personnel 51 (November-December 1974): 45-49.


29E. E. Lawler,


"New Approaches to Pay: Innovations That Work,"


Personnel 53 (September-October 1976): 11-


30Thomsen, pp. 124-31.


31See "A Benefits Shopping Spree," Computer Decisions


1983, pp.


27-28;


March


"Flexible Compensation Cuts Costs and Meets Employee


Needs," Personnel 60 (March-April 1983): 47-49


Stresses
11.


"Morgan Stanley'


Plan


Communication," Employee Benefit Plan Review 39 (February 1985):


SzA. Cole, Jr., "Flexibi
Relations," Personnel Journal 62


e Benefits Are a Key to Better Employee


January 1983)


49-53.


33See


oyees


. Velleman,


"Flexi bl


Benefits Packages That Satisfy


and the IRS," Personnel 62 (March 1985): 33-41


34See G.J. Stull


"Elective Compensation: Cafeteria Plans,"


Taxes--The Tax Magazine 63 (March 1985): 210-220;


"Electi


Compensa-


tion


Qualified Cash or Deferred Arrangements," T


(April 1985)


267-277


axes--


G.I. Lenrow and M. J. Cuddy,


The Tax Magazine
"The Cafeteria


Plan Struggle," National Underwriter Life and Health Insurance Edition,


June


, 1984, p. 11.


DR. G. Swad,
of the Impact of ESOP


"ESOP'S and Tax Poll


cy: An Empirical


Investigation


on Company Operating Performance." (Ph.D. disser-


station, The Louisiana State University and Aqricultural and Mechanical









38White,


"Employee Preferences for Nontaxabi


Compensation Of


fered in a Cafeteria Compensation Plan


An Empirical Study," pp. 539-61.


39Freeman, p. 509.

40Woodbury, pp. 166-82.

41For a validation of the paired-comparisons method versus "game


board" theory (i.e., asking emplo


yees


to allocat


dollar amounts to


fringe benefits),


see R.A. Lester,


"Benefits as a Preferred Form of Com-


sensation," Southern Economic Journal 34 (April 1967): 491.














CHAPTER


TAX TREATMENT OF FRINGE BENEFITS


Fringe benefits "may be defined generally


as any personal bene-


fit, other than cash paid as wages, which is furnished by an employer to


an employee because of the employment relationship."1


Generally, the tax


aws allow the employer to deduct the cost of these fringe benefits as


expenses in the current tax year.


subject to the Social Security Tax


Many of these fringe benefits are not

the Federal Unemployment Tax, and the


withholding requirements normally imposed on the employer.


The tax laws offer the employee tax-free treatment of a wide


range of current fringe benefits.


there are numerous Code Sections


that offer deferred tax treatment of certain other compensation-related


benefits.


Both of these areas are generally not subject to the Social


Security Tax and the withholding requirement


on employees.


The follow-


ing sections will discuss the fringe benefit movement and describe the


aforementioned employee compensation benefits that receive


preferential


tax treatment.


Fringe Benefit Movement


The notion of fringe benefits began in the middle of the 19th


Century with employers giving vacation pay to management emp


oyees


with







22

blocked by the government's wartime policies of limiting wage increases.


Unions then sought to


ease


employee demands by bargaining for fringe


benefits.


The War Labor Board allowed these benefits on the grounds that


they were not wage increases but merely noninflationary social benefits.

After the war, employees maintained a positive attitude toward


social benefits and security.

legislate for such benefits a

national health insurance. F


Unions again approached government to


is social security improvements and for a

ailing, in this respect, at the public


level


, the unions took their demands to the private sector.


Based on the


premi


that certain fringe benefits were necessary to provide for the


total welfare of the worker, the unions were successful in obtaining

benefits in the area of pensions and health insurance.

Employers entertained union demands for fringe benefits for


several reasons.


First,


excess


profits could be funneled to their own


employees in terms of these social benefits rather than having higher


taxes contribute to the social welfare of empl


oyees


in other industries.


Second


the Interna


Revenue Code of 1939 permitted lower payroll taxes


for the formation of pension trusts.


Third, employers believed that they


could increase productivity and reduce employee turnover through the


effects that the social benefits had on the worker.


Fourth, some fringe


benefits


severance pay


provided a "quid pro quo" feature in that


the employer was able to setti


employment disputes in an objective


manner.









recognized the advantages of the social effects of the fringe benefit

movement on increased productivity.4


Nontaxabi


Fringe Benefits


Over the years, Congress has

income of employees for varied reason


excluded specific items from gross


as to provide incentives


socially-desirabi


burden of tragedy (


activities (e.g., educational expenses


e.g., death benefits)


ease


or to promote certain economic


policy (e.g., energy saving through van pooling)


Twelve Code Sections


provide (or have provided) the tax-free treatment of certain employee


fringe benefits.5


These Code Sections are


Code Section


Enactment Date


Description of Provision


1964


The premiums paid by an employer for
group-term life insurance coverage up
to $50,000.


101(b)


1954


105(b)


1954


105(h


1978


Employer-paid death benefits, up to
$5,000, paid to a beneficiary by reason
of the employee's death.


Amounts received to reimburse an em-
ployee for medical care (including
spouse and dependents) under employer-
sponsored health and accident plans.


Amounts received to reimburse an em-
ployee for medical care (including
spouse and dependents) under employer-


qual ified


self-insured medical reim-


bursement plans.


1954


Premiums


paid


employer for


health and accident plans.


1954


Meals


and lodging furnished for the









Code Section


Enactment Date


Description of Provision


1978


1978


1978


1981


1984


Commuting expenses paid by an employer
under a qualified transportation (van
pooling) plan.


Life insurance premiums, health insur-
ance premiums and medical reimburse-
ments, group legal services, dependent
care assistance, and certain deferred
compensation arrangements received in
lieu of cash in a cafeteria plan.


Educational expense payments made by
an employer to a qualified plan.


Dependent care assistance payments made
by an employer to a qualified plan.


Fringe benefits that qualify as a no-
additional-cost service, a qualified
employee discount, a working condition
fringe benefit, a de minimus fringe
benefit, employee parking, subsidized


eating facility


, athletic facilities.


The following sections of this chapter will briefly examine each


of the above nontaxabi


teria plan r

Chapter 3.


ul


fringe benefits with the exception of the cafe-


of Code Section 125 that are examined in detail in


Also, a brief description of deferred compensation plans will


be included.


Section 79--Group-Term Life Insurance


Prior to 1964, group-term life insurance premiums paid by em-


players were


excluded from the employee's gross income.


Employers were


to deduct the premiums paid as ordinary and necessary business


expenses under Code Section 162. Congress


felt that this financial







25

Congress to believe that these amounts were paid in lieu of cash compen-

sation.6


Code Section 79 was enacted in 1964 to place limits on the


amounts of nontaxabi


group-term life insurance premiums.


Code Section


79(a) states that,

there shall be included in the gross income of an employee for the


taxable


year an amount equal to the cost of group-term life insurance


on his life provided for part or all of such year under a policy (or
policies) carried directly or indirectly by his employer (or em-


players)


but only to the extent that such cost exceeds the sum of--


(1) the cost of $50,000 of such insurance, and
(2) the amount (if any) paid by the employee toward the purchase
of such insurance.

Group-term life insurance is defined as a life insurance policy

carried by the employer that provides a general death benefit for at

least ten full-time employees (over the course of a calendar year) and is


based on a formula that encompasses such factors


as age, years of


serv-


, compensation, or job position and precludes individual


section for


the benefit.7

The cost of any premium, representing more than $50,000 in in-


surance coverage plus what the employee may have contributed


is included


in the employee's income based upon a table of uniform premiums pre-


scribed in the Treasury regulations.


Even if part of the premiums are


taxed to the employee, the employer still receives a deduction for the


total cost of insurance coverage provided.


Where an employee is ter-


minated and is either retired or disabled, or where the employer or a


charitable


organization is the beneficiary of the proceeds, the cost of









In 1982, Code Section 79(d) was added to further prevent the


employer from discriminating in favor of certain targeted emnpl


oyees.


Code Section 79(d) makes the actual cost of any insurance coverage pro-

vided to a key employee taxable to that employee if the employer plan

provides group-term life insurance coverage that discriminates in favor


of key empl


oyees.


A plan is considered discriminatory if it favors key


empl


oyees


n terms of eligibility standards and in terms of the type and


amount of benefits available


under the plan.


specifically, all benefits


availab


to key empl


oyees


must be availabi


to all other plan partici-


pants.


However, the value of the benefit provided to each empl


oyee


be proportional to the employee'


rate of compensation.


Code Sections 79(d)(3)(A


plan eligibility standards


and (B) set out


The rules


specific rules for the


state that (1) the plan must


benefit 70% or more of all employ


ees;


at 1


east


of the partici-


pants in the plan are not key empl


oyees;


and (3) the employer


classifica-


tion of employee groups must meet standards imposed by the Secretary of


the Treasury; or (4) the plan i


governed by the cafeteria plan rules of


Code Section 125 and must meet the nondiscrimination rules provided


therein.


In determining the eligibility standards, the employer may


exclude the following


asses


of employees: (1) employ


with 1


than


three years of service, (2) part-time or seasonal empl


oyees,


(3) em-


oyees


covered by a collectively-bargained agreement (meeting standards


imposed by the Secretary of Labor) where group-term life insurance bene-









without overcompensating key empl


oyees.


The employer can deduct the


amount of life insurance premiums paid


as an ordinary and necessary


business expense under Code Section 162.


The employer a


avoids paying


payroll taxes on the amount spent for these insurance premiums.


Section 101(b)--Employees' Death Benefits


Code Section 101(b), governing the taxation of certain employee


death benefit


was enacted in 1954 to reduce or eliminate the contro-


very of whether employer payments to an employee's beneficiary were


considered to be a gift.


This problem usually arose when an emp


oyee


not covered by life insurance.


If the beneficiary could prove that the


intent of the employer was to make a gift, then the payment would not


constitute taxable


income.


However


, if gift status could not be proven,


then the payment was considered to be compensation for prior servi


taxable


as any other form of income.10


Code Section 101 (b)(1) allows


employer payments, made to the beneficiary upon the death of an employee,

to be received tax-free up to the limitations of Code Section 101(b)(2).

Specifically, Code Section 101(b)(1) states that,


gross income does not include amounts received (whether in a


ngle


sum or otherwise) by the


beneficiaries or the estate of an emplo


yee,


if such amounts are paid by or on behalf of an employer and are paid
by reason of the death of the employee.


If the employer mak


an outright cash payment to the benefi-


ciary, then up to $5,000 of the payment could possibly qualify


as an


ordinary and necessary business expense depending upon the employer's






28


qualify for exclusion under Code Section 101(b), the employer can deduct

the payment as an ordinary and necessary business expense under Code


Section 162.


f the payment is a lump-sum distribution from a qualified


employer retirement plan, the beneficiary can exclude up to $5,000 of the


proceeds.


The payment i


not deductible by the employer


he/she


would have been deducting the plan contributions over the


fe of the


plan.


Certain limitations are placed on the amount and type of distri-


bution that qualifies under thi


provision.


The limitations are as


follows.


The maximum amount


excludable is limited to $5,000 with re-


aspect to the death of any employee.


If there is more than


one beneficiary, the $5,000 exclusion is apportioned among


the beneficiaries.


If the amount paid by the employer


ceeds $5,000, the


excess


may be


excl


uded under Code Section


102 as a gift depending upon the facts and circumstances

surrounding the payment.11


There is no


exclusion for amounts representing the employee


nonforfeitable rights (i.e., benefits that would have been

enjoyed if the employee had lived) except for lump-sum dis-

tributions from qualified stock bonus trusts, pension trusts,


profit-sharing trusts


There i


or qualified retirement annuities.


no exclusion for amounts representing a distribution









from a qualified stock bonus trust, pension trust, profit-

sharing trust, or a qualified retirement annuity.


Section 105(b)--Accident and Health Plans


There are several Code sections that deal with the taxpayer's


compensation for injury or sickness.


Conyres


felt that a taxpayer who


suffered bodily injury should not suffer additional pecuniary injury in


the form of a tax liability when h


he received financial


assistance to


cover medical expenses.12


Specifically, Code Section 105(b), which was


enacted in 1954, states that,


gross income does not include amounts


. paid, directly or


indirectly, to the taxpayer to reimburse
incurred by him for the medical care .


the taxpayer for


e


of the taxpayer


expenses
. his


spouse, and his dependents.

Medical care is defined in Code Section 213(d) as


"Amounts paid for the diagnosis, cure, mitigation, treat-


ment, or prevention of di


sease,


or for the purpose of af-


fecting any structure or function of the body."13

Transportation expenses to and from the source of medical

treatment.

Insurance premiums for medicare and medicaid.

Expenses for lodging incurred away from home if the expense


essential


to medical care and (a) the services are pro-


vided by a licensed hospital


physician


or the equivalent,


and (b) there


no element of personal pleasure, recreation,











available


30

The exclusion for medical services provided to dependents is only

e if the individual meets the relationship and support require-


ments for dependents found


n Code Section 152.


The other dependent


requirements do not have to be met.


Section 105(b) states that a child


of divorced parents is treated as a dependent of each party for the


purp


oses


of medical expenses regard


of who may be actually claiming


the dependent deduction.

Employee health and accident benefits received through an em-

ployer plan or through an insurance plan are afforded the same nontaxable


status.


The employer is allowed an expense deduction under Code Section


162 for plan contributions or insurance premiums, as the


case


may be.


Section 105(h)--Self-Insured Medical Expense Reimbursement Plans


Under the 1954 Code, employers have had the choice of providing

tax-free accident and health coverage to employees through either insur-


ance policies or through


could provide benefits in


self-insured plans.14


excess


self-insured plans


of insured plans as in the case of


meeting the dollar deductible for the employee.


Since there were no


discrimination standards that affected the accident and health insurance


area, these


self-insured plans could be used by employers to provide


disproportionate benefits in favor of targeted groups (e.g., key em-

ployees or the management group).15

In 1978, Code Section 105(h) was enacted to place discrimination

standards on any accident and health olans of the emolover that were not









amounts to the extent they constitute an excess reimbursement of
such highly compensated individual. [Emphasis added.]16


self-insured plan could not discriminate in favor of highly


compensated individual

did discriminate as tc


as to eligibility to participate.


eligibility standards


If the plan


, then the highly compensated


individual had to include a portion of the reimbursement in gross income.

The self-insured plan could not discriminate in favor of highly compen-


sated individual


as to the benefits provided under the plan.


Specifi-


cally, Code Section 105(h)(4) stated that the benefits provided to highly


compensated individual


had to be provided to all plan participants


the plan did discriminate as to the amount or type of benefits available,

the highly compensated employee had to include in income the amount of


reimbursement he/she received in


excess


of whatever all other empi


oyees


would have received for the same claim.

Code Section 105(h) was repealed generally for tax years begin-


ning after December 31, 19


However, the benefits of th


self-insured


plans are now covered under Code Section 89 with more stringent non-

discrimination rules.


Employer expenditures for a


self-insured medical reimbursement


plan are deductible as ordinary and necessary business expenses under

Code Section 162.


Section 106--Employer Contributions for Accident and Health Plans


Prior to 1954


, the premiums that employers paid to insurance com-









employee.


In either


case,


the employer's expense was deductible under


Code Section 1


The 1954 Internal Revenue Code sought to equalize the


tax status of the source of funding of employer-sponsored accident and


health plans by enacting Code Section 106.17


It states that


gross income does not include contributions by the employer to ac-
cident or health plans for compensation (through insurance or other-


wise


to his employees for personal injuries or sickness.


Employers continue to receive a business expense deduction for these

fringe benefit payments made either as a contribution to a fund or

through insurance premiums.


Section 119--Meal


and Lodging


It is well established in the tax laws that gross income may take


the form of money, property, or services.1


In many instances, the


medium of exchange does not


oud the essence of a taxabi


transaction


e.g., the receipt of a check in


ieu of cash, the receipt of property in


lieu of cash, or the receipt of services in lieu of cash)


However,


there are times where the medium of exchange, coupled with the circum-


stances


involved, overlaps to include areas of taxation (personal gain by


the taxpayer


with areas of expense (inconvenience of the taxpayer)


highly-litigated fringe benefit area has been Section 119 which deal


with employee expenses for meals and lodging of the employee.19


Code


Section 119(a) was enacted in the 1954 Code to provide that

there shall be excluded from gross income of an employee the value of


any mea


or lodging furnished to him, his spouse, or any of his


dpnpndpnt hv nr nn hphalf nf hi pmnlnver for thp c nnvenince of the









The existence of an employment contract or a State statute that governs

the terms of employment is not controlling in determining whether the


value of meal


or lodging is compensation to the employee.20


Meal


exclusion.


Two tests must be met to exclude the value of


meals: (1) the meals must be furnished for the convenience of the em-


player and (2) the meals must


furnished on the employer


s business


premises.


The Regulations21 state that the meals must be furnished for a


substantial noncompensatory reason in order to satisfy the "convenience


of the employer" test.


Circumstances that would qualify include meal


furnished at no charge to empl


permit employ


oyees


to be available


during working hours in order (1) to


for emergency situations; (2) to permit


oyees


to be on duty during the meal hour; or (3) to remedy a problem


caused by short meal periods and insufficient eating facilities in the


ocale of the business premi


Where meal


ses.


are furnished at an unvarying charge irrespective of


whether the employee accepts the meal


the value of the meals will not


be taxable


compensation to the employee


if the meals were provided for a


substantial noncompensatory reason of the employer.


This differs from


the situation where the employer furnishes meals and the employee has the


choice of paying the charge or providing his own meal.


case, the meal


In this latter


are not considered to be for the convenience of the


employer, and the value of the meal


provided would be taxable to the


employee.









location where the employer carries on a significant portion of his

business.


Lodging exclusion.


Three tests must be met to


exclude the value


of employer-provided lodging:


convenience of the employer; (


the lodging must be furnished for the


the lodging must be furnished on the


employer's business premises


and (


3) the employee must be required to


accept such lodging as a condition of hi


employment.


The first two tests are definitionally the same


as those for the


meal


exclusion.


The third test necessitates that the employee be


quired to accept the lodging in order for him to properly perform his


duties.


In other words, the employee would be hindered in performing his


duties if lodging were not provided.24


Amounts spent for employee meals and lodging are deductible


ordinary and necessary business expense under Code Section 162.


Section 120--Qualified Group Legal Services Plans


In the 1970's, the American Bar Association began promoting the


concept of group legal


service plans in order to make legal servi


more


available to the general public.


At the same time, many unions had


established such plans through the partial or total financial support of


the employer.


The employer would deduct amounts contributed to the plan


or the reimbursements made directly to employees under a plan,

nary and necessary business expenses under Code Section 162.


as ordi


The em-


nlnvpp hnwev Pr wa< tarYpr n nithr ths nlAn n rnntrihbitinnc nr tha raim-










behind creating this additional tax-favored fringe benefit.


First, Con-


gress wanted to increase the


access


of employees to legal services by


encouraging employers to offer these plans and encouraging employees to


participate in these plans as par

Congress intended to increase the


t of a fringe benefit package.


access


Second,


that middle-income taxpayers


had to legal servi


ces.


Low-income taxpayers already could avail them-


selves


of publicly-supported legal aid


services.


High-income taxpayers,


presumably y


could afford to provide their own legal


services.


Third,


Congress believed that providing favorabi


tax treatment for


egal


serv-


ices


would help to relieve the high cost of legal services.


Code Section


120(a)(1) stated that,


gros


income of an employee


, his spouse, or his dependents, does not


include--
(1) amounts contributed by an employer on behalf of an employee,
his spouse, or his dependents under a qualified group legal services


pi an


or
(2) the value of legal serve


ices


provided, or amount


legal services, under a qualified group legal services plan


to, or with respect to


an employee, hi


spou


paid for


or his dependents.


A qualified group legal services plan had to satisfy the follow-

ing requirements.


A written plan had to be created by the employer.


Proposed


Regulation 1.120-2(b)(2) stated that no other type of benefit (pension,


health, etc.) could be included in this plan.


Sole proprietorships and


partnerships were both considered to be employers under those types of


organizations.


Contrary to many fringe benefit provisions, proprietors


-n .. -, 4. .Cn n nr ...n nfl


"til **fl I~ lllr Ull 1A1 ti %i il t


to hp treated as pmnl


o vees.


r









disabled,


aid-off, on leave, or


self-employed.


Former separated em-


oyees


could be included on a self-contributory basis for no more than


one year after separation.


Determination of whether an individual was a


spouse of an employee was made at the time when services were rendered.

Dependents had to meet the relationship and support tests of Code Section


152.


The regulations also stated that the plan could provide


egal serv-


ices


for an administrator of an estate of either the employee, spouse,


or dependents.


The plan had to provide benefits pertaining only to personal


egal services.


Proposed Regulation Section 1.120-2(c) stated that the


services could not include legal matters that relate to areas involving

the trade, business, investment opportunities, or the collection of


income of any plan participants


relating to alimony, will


jury suits.


However, services could include matters


and the contesting thereof, and personal in-


Initial consultations, on a limited time or frequency basis,


made to establish whether the employee was in need of legal service were

permitted even though nonpersonal matters could be discussed.


Legal servi


included activities performed by a lawyer or per-


formed under his direct control (e.g


services of a paralegal


clerk, accountant, researcher, etc.)


Fees paid to third part


(e.g


for court services


, summons, bail etc.,) could be paid by the plan to the


extent that they did not represent the payment of a tax.


The plan could not discriminate in terms of plan contribu-









targeted group.


For exampi


a plan that varied benefits based on years


of service would not be considered discriminatory whereas a plan that

varied benefits based on compensation would be considered discriminatory.

5. The plan could not discriminate as to eligibility to partici-


pate in favor of employees who were officers, shareholders,


individuals, or highly compensated.


self-employed


The employer could exclude employees


who were governed by a collectively-bargained plan (as defined by the


Secretary of Labor


where group


egal plan benefits had been subject to


good-faith bargaining.


No more than


of yearly plan contributions could be pro-


vided for empl

dependents).


oyees


who are shareholders or owners (or their spouses or


Shareholders or owners were defined as individual


who, on


any day of the year, owned more than five percent of the stock or more

than five percent of the capital or profits interest in the employer.

Proposed Regulation Section 1.120-2(f)(5)(ii) specified that if the plan

failed this contribution limitation test for three successive years, the


plan was disqualified at the beginning of the next year.


Reapplication


for qualification was subsequently allowed by Proposed Regulation Section

1.120-2(f)(5)(iii).


The employer had to apply for initial plan qualification.


Regulation Section 1.120-3 specified that Form 1024


Application For


Recognition of Exemption Under Section 501(a) or For Determination Under


Section 120


and Schedule L had to be filed with the key district direc-









Amounts contributed under the plan had to be paid only to


insurance companies, to providers of legal services, to a trust formed

specifically to administer a qualified group legal services plan, or to a


tax exempt organization which pays


or credits the employer contribution


to another organization or trust that is formed specifically to adminis-

ter a qualified group legal services plan.

9. Every post-1984 group legal services plan had to file an an-

nual information return with the Secretary of the Treasury in accordance

with the provisions of Code Section 60390.


Since the benefit


of Code Section 120


expired on December 31,


1987


, empl


oyees


now must include the value of thi


benefit in gross


income


, according to the rul


of Temporary Regulation Section 1.61-2T


should the employer extend this service plan beyond the above date.


Section 124--Qualified Commuting Expenses


Commuting expenses of an employee to and from work do not qualify


as deductible


business expenses.


With the passage of the Energy Tax


Act of 1978, Congress intended to decrease the consumption of gasoline by


encouraging taxpayers to carpool.29


fringe benefit wa


To accomplish this, a tax-free


provided to employees by way of encouraging employers


to furnish cost-free group transportation.


Code Section 124(a


stated


that,


gross income of an employee does not include the value of qualified


transportation provided by the employer between the emplo


yee' s


resi-


dence and lace of emDlIovment.







39

transporting employees to and from work on trips in which at least half

of the seating capacity (not including the driver) was occupied.

The employer had to set up a separate written plan to provide


these benefits.


The plan could not discriminate in favor of employees


who were officers, shareholders


or highly compensated.30


The plan had


to state that the employees were receiving transportation benefits cost-

free from the employer and not in lieu of any compensation.

The employer could deduct the operating costs of a qualified

transportation plan as an ordinary and necessary business expense under


Code Section 162.


The cost of the "highway commuter vehicle" also quali-


fied for the investment tax credit.


Since the benefit


of this Code Section


expired on December 31,


1985, employees now must include the value of this benefit in gross in-


come, according to the rul


of Temporary Regulation Section 1


1-2T,


should the employer extend this service beyond the above date.


Section 127--Educational Assistance Programs


Prior to 1978, a taxpayer could exclude from gross income educa-


tional payments that qualified


as either a scholarship (or fellowship)


under Code Section 117 or as work-related tuition reimbursements under


Code Section 162.


Also, nonreimbursed business-related educational


expenses were deductible under Code Sections 162 and 21


In enacting Code Section 127, Congress intended to foster the

arnwth of education nationwide bv nrovidina a special tax incentive to










provide the employer with benefits of increased productivity.


Under


Code Section 127(a),


gross income of an employee


does not include amounts paid or expenses


incurred by the employer for educational assistance to the employee
if the assistance is furnished pursuant to a program which is described
in subsection (b).

"Educational assistance" was defined as (1) amounts paid to, or


on behalf of, the employee for education


fees, books


expenses including tuition,


supplies, and equipment, and (2) the fair market value of


educational benefits provided directly by the employer including books,


supplies, and equipment.


The educational benefits did not need to be


job-related or be required


as part of a degree program.


"Educational


assistance" did not include (1) the expenses for, or the value of


or supplies that are retained by the employee; (2) meals, lodging, or

transportation; (3) the payment for, or the value of, courses involving


sports, games, or hobbies unl


the education was related to the em-


ployer


business or was required


as part of a degree program


The maximum yearly


was $5,000.


exclusion for each employee under Section 120


However, educational benefits that qualified under either


Code Sections 117, 162, or 212, did not count against the dollar ceiling.

The employer could deduct these payments as ordinary and necessary bus-

iness expenses under Code Section 162.

In order for the employee to exclude the educational benefits

from gross income, the employer had to set up a formal program pursuant


to Code


Section 127(b)


This formal program of educational


assistance


.


w







41

to be funded, but the employer had to give notice of the plan to all el-


igible empl


oyees.


Regulation Section 1.127-2(b) stated that the educa-


tional


assistance plan could be part of a more comprehensive plan of the


employer which provided other nontaxable benefits to its emp


oyees.


proprietors and partnerships were considered to be employers for Section


127(b


oyees


purposes.


The plan had to exist for the exclusive benefit of the en-

Regulation Section 1.127-2(d) stated that the employer, at his


discretion, could include in the plan employees who were retired, dis-


abled, laid-off, or on leave.


Sf-employed individual


were considered


oyees


under this section.


The plan could not include the educational


expenses of the employee


spouse or dependents unl


these individual


were al


an employee of the employer.


The plan had to benefit employees who qualified under a


lassification scheme set up by the employer which did not discriminate


in favor of employees who were officers


owners, highly compensated.33


The employer could exclude empi


oyees


who were governed by a collectively-


bargained agreement (as defined by the Secretary of Labor) where educa-

tional assistance benefits had been subject to good-faith bargaining.

A plan was not discriminatory if the favored group of employees


merely made use of the plan assistance moreso than other emp


oyees.


Also, a plan was not considered discriminatory if the employer imposed

certain constraints on the employees before making the benefits avail-







42


No more than five percent of the yearly plan assistance ben-


efits could be attributed to empl


oyees


who were shareholders or owners


(or their spouses or dependents) of the employer.


Shareholders or owners


were defined


as individual


who, on any day of the year


owned more than


five percent of the stock or more than five


percent of the capital or


profits interest in the employer.


The plan could not offer the choice between education


distance benefits and other taxabi


benefits.


Post-1984 educational assistance plans had to file an annual


information return with the Secretary of the Treasury in. accordance with

the provisions of Code Section 60390.

Since the benefits of this Code Section expired on December 31,


1987, employees now must include the value of thi


income, according to the rul


benefit in gross


of Temporary Regulation Section 1.61-2T


should the employer extend this service beyond the above date.


Section 129--Dependent Care Assistance Programs


Since 1963, there has been some relief in the tax law for indi-


vidual


who incurred expenses for the care of dependents in order to be


gainfully employed.


Code Section 214 (now repealed) provided an itemized


deduction for only a limited amount of the actual expense incurred by the


taxpayer.


For those taxpayers who could not itemi


vided no relief.


The Tax Reform Act of 1976 replaced the


this section pro-


itemized deduc-


tion with a tax credit.









dependent; $4,800 for


or more dependents.)


The tax credit does not


reimburse the taxpayer, dollar for dollar, for the expense incurred.

only provides partial relief.

The Economic Recovery Tax Act of 1981 established an incentive

for employers to establish a dependent care assistance program for its

employees by allowing the benefits provided by these plans to their


empl


oyees


to be tax exempt.


Employers receive a deduction under Code


Section 162 for amounts contributed to the program.


Code Section 129(a)


states that,

gross income of an employee does not include amounts paid or incurred


by the employer for dependent care assistance provided to


ployee if the assistance is furnished pursuant to a program which is
described in subsection (d).


"Dependent care assistance," defined in Code Section 129(e)(1)


is employer payments for, or provisions of, services that represent


penses for household servi


or expenses for the care of "qualified


individuals" (dependents) that an employee would incur to enable


employee to be gainfully employed.


Regulation Section 1.44A-1(c)(2)


states that household services encompass the ordinary and usual services

necessary to maintain the taxpayer's household and must be attributed in


part to the care of dependents


For exampi


the services of a maid or


cook would constitute household services but the servi

or gardener would not constitute household services.


of a bartender


Regulation Section


1.44A-1(c)(3) states that expenses for the care of a dependent would be

of the nature to assure thp wpll-hpinn and nrntprtinn nf thp nlnalifipl


uch em-









grade


level


or above does not qualify as dependent care.


"Dependent care


assistance"


does not


include payments to a dependent of the employee nor


to a child of the employee who is under the age of 19 at the


taxabi


lose of the


year.


A "qualified individual


as defined in Code Section


1(b)(1),


a dependent of the taxpayer under the age of 15 for whom the taxpayer


is entitled to a dependency deduction or (


taxpayer who is mentally or physically handic


a dependent or spouse of the

apped. Payments for serv-


ices c

21(b)(


outsidee


of the employee

for the employee


home are allowed by Code


dependents under age


tion


and are allowed


for all


other qualifying individual


if they spend at


least eight hours


each day in the employee


s household.


Therefore,


enses


incurred for


nursing home services


for the elderly would not qualify


as dependent care


assistance.


These latter payments,


however, may qualify


as deductible


medical


expenses.


Exclusion


limitation.


Code


Sections 129(a)


and (b)


impose a


limitation on the amount of gross

The exclusion for an unmarried emp


income that may be excluded annual


limited to his/her earned


income.


The exclusion for a married employee i


s limited to the earned


income of the employee or the spouse, whichever is


power.


Amounts that


qualify


.as an exclusion from income


under Code Section 129 are ineligible


to be counted as expenses for child or dependent care purposes.


Code


Sect


ion 32(c)(2) defines earned income


as wages,


sal aries









each month of such status,


month if one dependent


is deemed to be an amount equal


involved ($400 per month


to $200 per


if two or more depen-


dents are involved).


Dependent care assistance program.


In order for the employ


exclude the dependent care


assistance payments from income,


must set up a separately written plan,


employees,


for the


that provides dependent care assist


the employer


exclusive benefit of the

nce. The plan need not be


funded.


The employer must notify all


eligibi


employees


of the existence


and the terms of the plan.


Also,


the plan must furnish


on or before


January 31st, a written statement to all


employees which indicates the


amount of dependent care assistance provided to each individual


during


the previous calendar year.


The plan must not di


scriminate as to contributions or benefits


favor of employees who are officers, owners, or highly compensated, or


their dependents.34


The employer may


exclude employees covered by a col-


ectively-bargained plan (as defined by the Secretary of Labor)


pendent care assistance had been the subj


No more than


if de-


ect of good-faith bargaining.


of the plan expenditures may be provided for


employees who are shareholders or owners (or their spouses or dependents


of the employer


Shareholders or owners are defined


individuals who,


on any day of the year, owned more than five percent of the stock or more


than five percent of the capital


or profits


interest


in the employer.


The plan i


not discriminatory if the favored group of


employees merely









Section 132--Certain Fringe Benefits


The fringe benefit area, for more than a decade, has been a con-


troversial area for both the IRS and taxpayer alike.


Specifically, the


focus of the argument has been the realm of nonstatutory fringe benefits.

In the past, Congress usually has followed the initiative of the public


sector in determining which benefits to


exclude from income.35


As em-


players attempted to be creative and competitive with fringe benefits,


the issue of gift (nontaxable) versus taxabi


early as 1921


compensation emerged.


the IRS ruled that free railroad passes to employees were


determined to be tax-free gifts.


Because of such administrative rulings,


taxpayers began to expand the area of nonstatutory fringes.


A growing


"erroneous" perception that nonstatutory fringe benefits were nontaxable


became evident.


The IRS dismissed many of the


cases


on de minimus


grounds.


However, as inflation took it


toll on revenue collections, the


Treasury decided to take a stand.


In 1975, the Treasury circulated a


draft of proposed regulations outlining the rul


for nontaxable


fringes.


The public


opposed the draft so vehemently such that the draft was subse-


quently withdrawn.


In 1978, Congress imposed a moratorium on the is-


suance of Treasury rulings and regulations under Code Section 61 with

respect to the income tax treatment of nonstatutory fringe benefits.

This moratorium was extended several times until it was due to expire on

December 31, 1983.


On July 18, 1984


President Reagan


signed into law the Deficit









The committee believes that by providing rules which essentially
codify many present practices under which employers provide their own
products and services tax-free to a broad group of employees, and
by ending the uncertainties arising from a moratorium on the Trea-
sury Department's ability to clarify the tax treatment of these
benefits, the bill substantially improves the equity and administra-
tion of the tax system.36

The Conference Committee Report states that the legislative mora-

toriumf on the issuance of regulations by the IRS is not to be extended.


legislation enacts provisions to


exclude certain fringe benefit


from


the Federal income tax


eral unemployment taxes.


aw as well as from the social security and fed-

Any fringe benefit not qualifying under the new


law or under any existing statutory fringe benefit provision is to be

included in gross income and in the base for employment taxes at the


excess


of the benefit's fair market value over the amount paid


, if any,


by the employee


for the benefit.


Code Section 132(a) excludes from gross income any fringe benefit


which qualifies as a (1) no-additional-cost service,


) qualified em-


ployee discount, (3) working condition fringe, or (4) de minimus fringe.

These four exceptions are explored below.


No-additional-cost service.


To qualify under this exception, the


service provided by the employer to his employees must be the same


that provided to nonemployee customers.


service must be in the


same line of business as the one in which the employee is employed.


so, the employer must not incur any substantial


additional cost (in-


cluding foregone revenue) in providing the service to the employee. In






48


the service at no charge, or at a reduced rate, or offers a rebate to the

employee.

The House Ways and Means Committee Report for the 1984 Tax Act


provides the rul


for the line of business requirement.


These require-


ments were imposed to avoid inequities between employees of


large con-


glomerates that operate in many lines of business


as opposed to empl


oyees


working for a smaller employer who generally would operate in only a


single


line of business.


An employer has more than one line of business


if the products or services


sold to nonemployee customers fa


into more


than one industry group.

If an employee performs services that benefit more than one line


of business of the employer (e.g


accountant, attorney, etc.), then the


no-additional-cost servi


that may be


excluded by the employee include


those provided by all lines of business that are served.


Code Section 132(g)(1) states that all employees


of corporations


that are members of a controlled group (e.g., parent-subsidiary, etc.,)


are to be treated as employees of a sing


employer.


This rul


also ap-


plies to employees of proprietorships or partnerships under common con-


trol and to employees of affiliated service groups.


The line of business


rules, however, remain intact.

Code Section 132(g)(2) permits two unrelated employers to under-


take a reciprocal arrangement to provide empl


oyees


of both firms with


no-additional-cost services of either firm.


The arrangement must be in






49


Employees include those that are (1) currently employed, (2) re-

tired or disabled, (3) widows or widowers of the retired or disabled

employees, (4) spouses or dependents of the currently employed, retired,


or disabled


Benefits provided as no-additional-cost serve


ices


to em-


oyees


who are officers, owners, or highly compensated37 will be


clouded from income if the benefits are provided on substantially the same


terms to all employees under a


classification set up by the employer


which does not discriminate in favor of these individuals.


Otherwise,


these favored employees would be subject to federal income and employment


taxes on the


excess


of the fair market value over any amount paid by the


employee for the benefit. The

employer may set up an employee


House Committee Report states that the


lassification based on seniority, full-


time versus part-time employees, or job description as long as the effect

is not discriminatory.


Qualified employee discounts.


Gross income does not include the


value of a discount that the employee receives on qualified property or


services of the employer subject to several constraints.


The discount


offered may either be a reduction in price or a third-party cash rebate.


The tax-free discount is only available


on "qualified" property.


Qualified property includes any property, not including real estate or

property commonly held for investment, that is sold to nonemnployee cus-

tomners in the same line of business in which the employee is employed.


The House Committee Report specifically excludes such property


as secur-






50


apply here as they did for the no-additional-cost service except that no


exclusion is availabi


for discounts involving reciproca


arrangements


between two unrelated employers.


The excludabI


discount made availabi


to the employee for serv-


may not exceed 20% of the ordinary selling price of the service.


With respect to "qualified" property, the excludable discount may not


exceed the employer


profit percentage.


computed upon the aggregate sal


s selling price multiplied by the employer's gross


selling price and cost of the merchandise may be


of a specific line of business (e.g


department store) or the employer may set up a reasonab


for the computation (e.g


assification


high-markup items versus low-markup items


The cost of the merchandise is computed under the prevailing inventory


of Code Section 471.


The term,


"employee," is defined the same as it was for the


no-additional-cost services.


apply here


Also, the same nondiscrimination standards


as they did for the no-additional-cost services.


Working condition fringe benefit.


To qualify as a working condi-


tion fringe benefit, the property or services provided by the employer


must be of the nature that, if the employee paid for such benefit, it

would have qualified as an employee business expense under Code Sections


162 or 167.


The House Committee Report states that working condition


fringe benefits may constitute (1) employee use of a company car or plane


strictly for use in the employer'


business


(2) employer expenditures






51


The fair market value of any property or services consumed by the


employee for personal reasons must be included in the emp


oyee' s


gross


income unless it qualifies


low).


as a de minimus fringe (


The House Committee Report al


next section be-


includes, in the working condition


fringe benefit


classification, any property or services that the employer


may provide because of safety precaution


when the benefit constitutes an


ordinary and necessary business expense for the employer.


Accordingly


there are no nondiscrimination standards that must be applied to working

condition fringe benefits.


Special rul


(e.g., cars, boats, et


apply when an employer manufactures a product

c.,) for sale to nonemployee customers but allows


the employee to use the product away from the business premises for


product testing and evaluation.


The employee


use of the product is


considered a working condition fringe benefit only if the following


conditions are met

necessary business


1) product testing and evaluation i


expense of the employer


an ordinary and


(2) testing procedures cannot


be adequately accomplished on the employer


s premi


ses;


the product is


furnished to the employee for the sol


purpose of product testing and


evaluation; (4) the product is furnished to the employee for only the


time necessary to complete the testing and evaluation procedures


(5) the


employer imposes limitations on the use of the product to dimish its


value to the employee (


e.g.


no choice of model or color, prohibited use


by family members); (6) the employee must submit records of the product






52

the auto must be provided to a full-time salesman for use in the area of

the dealer's premises, must be furnished to facilitate the salesman's

performance, and the employer must place substantial restrictions upon


the use of the auto.


Temporary Regulation Section 1.132-1T(A-4a) indi-


cates that there will be no exclusion for working condition fringe hene-


fits that relate to the use of company autos unl

records that substantiate the use of the auto.39


De minimus fringe benefit.


the employee provides


The fair market value of property or


services provided by an employer to the employees which, after taking

into account the frequency of usage, is so small that accounting for the

benefit is unreasonable or administratively impractical is considered a


de minimus fringe benefit.


The House Committee Report gives the follow-


ing examples of de minimus fringe benefits: the typing of personal let-

ters by the company secretary, personal use of a copy machine, occasional

employee cocktail parties or picnics, supper money or taxi fares provided

to employees who work overtime, employee holiday gifts having a small

value, theatre or sporting event tickets, and coffee and doughnuts fur-

nished to the employees.


An employer subsidy for employee meal


that are obtained in a


facility operated by the employer may qualify as a de minimus fringe


benefit.


Code Section 132(e)(2


permits the


excess


of the fair market


value of the meal


over the charge made to the employees to qualify


as a


de minimus fringe benefit if three requirements are met.


First









owners, or highly compensated.40


Otherwise,


these individual


must


lude the value of the


subsidy in gross income


Athletic facilities.


Code Section 132(a) does not


include ath-


letic facilities as


one of the


excludable fringe benefit


assi fications.


Code Section 132(h)(5)


exclude


from gross


income the value of


athletic


facilities operated by the employer on his premi


which are used pri-


marily by the employ


ees,


their


pouses, and their dependent children.


The House Committee Report


specifies that the athletic


facility need not


be on the business premises but must be on premises owned by the em-


player.


Such facilities may include a swimming pool, gym,


tennis court


or a golf


course.


Membership fees in a country


club will


not qualify for


exclusion from gross


income under this section unless the club


and operated by the employer and meet


the employee usage


owned


requirements of


this section.


Code


tion 274(e)(5)


imposes nondiscrimination require-


ments on the employer in order to qualify athletic facility expenditures

as a business deduction.


Deferred Compensation Plans41

Various forms of deferred compensation schemes have also been af-


forded preferential


tax treatment.


Deferred compensation arrangements


arise when an employer obligates himself to pay compensation to an em-


ployee in the future


in addition to


, or as a


substitute for,


current


compensation.


The tax consequences to employers and empl


oyees


are depen-


dent upon the nature of the plan.









were originally enacted under the Interna


Revenue Code of 1939.


Sub-


stantial revisions have been made to these ru


over the years, notably,


through the Employee Retirement Income Security Act of 1974 (ERISA).

The employer receives a tax deduction in the year of contribution


to the plan within the limits of Code Section 404.


The employee is not


taxed on these current contributions made to the plans nor taxed on any


earnings that are permitted to accumulate. The employee is taxed when

the benefits are distributed or made available.


Salary Reduction Plans


Private retirement plans have been in existence prior to the De-

pression years and rapidly expanded during the World War II era.42 Al-


though Congress had addressed pension reform in the drafting of the 1939

Code by 1974 several creative retirement plans were causing difficult

policy issues.43


cases


where the employer could not afford to set up a penna-


nent retirement plan, one alternative was to offer a salary reduction


plan.


A qualified plan (trust) was formed but the empl


oyee


had the


choice to take his current compensation in cash or to have a certain


portion of his compensation contributed to the plan.


These plans were


known


as cash or deferred profit-sharing plans.


Under pre-1974 law, this


type of qualified plan allowed the employer an immediate pension deduc-

tion and allowed the contributing employee to exclude that portion of


income from the tax base.


Both emolover and pmoloveP were exemnt from









better rulings and the IRS issued three Revenue Rulings to demonstrate


the acceptable


participation and discrimination standards.44


Ry 1972,


the IRS began questioning the proliferation of these types of arrange-


ments and modified it


position by issuing proposed regulations.


In the ERISA pension reform measures of 1974

ferred profit-sharing arrangements were addressed.

the ability of taxpayers to create new plans. Exist


their tax benefits.


, the cash or de-

Congress restricted


ing plans retained


New plans had to request an advance IRS ruling to


obtain the desired tax advantages.


Otherwise, new plans would subject


employees to current taxation on amounts contributed to the plan.


Nonqualified Deferred Compensation Plans


Usually, nonqualified deferred compensation plans arise when an

employer makes a promise to reward an employee for future services with a


payment to be made at a future date (i


retirement.)


.e., at the time of the employee's


These plans have no qualification standard and can com-


pletely discriminate in favor of key employees, executives, or any target


group.


No IRS approval is necessary for plan adoption nor for its sus-


pension, revision, or termination.


The plan may be unfunded or funded.


Stock Options


Stock options compensate employees by offering future ownership


in a firm.


The employer offers the stock option with certain restric-


tions (e.g., option price, exercise rights, etc.,)


as an incentive to









The tax consequences of stock options to both the employer and

the employee depend upon whether the stock option meets the statutory


requirements of the tax law or fall


into the nonstatutory area.


Notes


1"Statement by John E
Tax Policy, at Hearing June 2


Chapoton, Assistant Treasury Secretary for
, 1983, by Senate Finance Committee and


Joint Committee on Taxation Staff Pamphlet Giving Overview of


640,


Administration's Proposal to Cap Exclusion for Employer-Provided Medical
Care, and Tax Treatment of Other Fringe Benefits, Considered at Hearing,"


Daily Tax Report No. 121, June


1983, p. J-16.


2See


Code Section 162(a) regarding ordinary and necessary business


expenses.

3The Social Security Tax is assessed on both the employer (Code


Section 3111) and the employee (Code Section 3101).


Code Section


3121(a) for the definition of wages for the purpose of the Social


curity Tax.


The Federal Unemployment Tax is an excise tax imposed on the


employer (Section 3301).


Code Section 3306(b) for the definition of


wages for the purpose of the Federal Unemployment Tax. See Code Section
3401(a) for the definition of wages for purposes of the withholding re-
qui rements.


4For a detailed analysis of the fringe benefit movement,


see


F.M. Wistert, Fringe Benefits (New York


Reinhold Publishing Corporation,


1959)


pp. 1-80.


5Since the data gathered for thi


1986, the tax law


study were completed by spring,


ited reflects the law that was in effect when the


study was undertaken.


Any law that has been repealed or expired


since


that time has been so noted in the text.


.5.,


tember 13


Congress, House, House Report No. 749, P.L.


88-272


, Sep-


1963, by West Publishing Company, House Ways and Means Commit-


tee Print (Washington, D.C.: Government Printing Office


1966), p


. 1310.


7Regulation Section 1.79-1(a).

8U.S., Congress, House, The Tax Equity and Fiscal Responsibility
Act of 1982, Pub. L. 97-248, 97th Cong., 1982, Section 244(a).









10See Revenue Ruling


102, 1962-2 C.B. 37 and Estate of Sydney


J. Carter v. Commissioner, 453 F.2d 61 (CA-2, 1972).

11Revenue Ruling 62-102, 1962-2 C.B. 37.

12Epmeier v. United States, 199 F.2d 508 (CA-7, 1952).

13Code Section 213(d)(1)(A).

14Code Section 105(e).


95-1263 on


., Congress
P.L. 95-600


Senate, Senate Finance Committee Report No.


, by Commerce Clearing House, Inc.


Finance Committee Print (Washington, D.C.


Senate


: Government Printing Office,


September


1978), pp


. 186-87


16A highly compensated individual is defined under Code Section


105(h)(5)


as (1) one of the five


holder of the employer, or (3) one of the


highest paid officers, (2) a 10% share-


highest paid employees of


the employer (not counting employees who may be excluded for purposes of


the plan).


A shareholder is defined by the attribution rules of Code


Section 318 which detail the ownership of stock through family members,
partnerships, estates, trusts, corporations, and by option.

17U.S., Congress, House, House Ways and Means Committee Report No.


1337, by Commerce Clearing House, Inc., Hou


Ways and Means Committee


Print


Washington D.C.: Government Printing Office, 1954), p


18Regulation Section 1.61-(1)(a).


19Wel1 over 100 court


cases


have been litigated under Code Section


20Code Section 119(b)(1).

21See Regulations Section 1.119-1(a)(1), 1.119-1(a)(2), and
1.119-(1)(a)(3).

22Regulation Section 1.119-1(a)(3)(i).


23Revenue Ruling 71-411, 1971-2 C.R


. 103.


24Regulation Section 1.119-1(b).

25U.S., Congress, Senate, Senate Finance Committee Report No.
94-938, Part II on P.L. 94-455, by Commerce Clearing House, Inc.. Senate


. 15.









27Proposed Regulation 1.120-2(i)(3) stated that an officer was


defined under the regulations for Code Section 414(c).


11.414(c)(3)(d)(3) defined an officer as including the president, vice
presidents, general manager, treasurer, secretary, and comptroller of a


corporation.


A shareholder was defined by using the attribution rules of


Code Sections 1563(d) and 1563(e) which detail the ownership of stock
through corporations, partnerships, estates, trusts, other family rela-


tionships, and by option.


not attributable


(Stock owned by a qualified employee trust was


to any taxpayer.)


Proposed Regulation l.120-2(i)(5)


stated that a highly compensated individual would be determined by the
4 ^-. -* j j .*


regulations under Code Section 410(b)(1)(B).


(1)(d)(1) stated that a determination of a highly compensated individual


was based on all of the facts and circumstances, taking into
amout ofcomensaion hatan eploye rceivdi reaionto tecm


amount of compensation that an employee received in relation to the com-
pensation of all other employees of the employer.

28Regulation Section 1.162-2(e).


29U.S., Congres


Senate, Senate Finance Committee Report No.


95-529 on P.L. 95-618, by Commerce Clearing House, Inc


Committee Print (Washington, D.C.: Government Printing Office, October
21, 1977), p. 59.


30There are no regulations governing Code Section 124.


The pre-


sumption is that the definitions that applied to Code Section 120 will
be applicable to this Code Section.


31Regulation Section 1.162-5.


32U.S., Congress,


Senate, Senate Finance Committee Report No.


95-1263 on P.L. 95-600, pp. 100-101.


33See


Note


34There are no regulations governing Code Section 129.


The pre-


sumption as that the definitions that applied to Code Section 120 will


be applicabi


to this Code Section.


35For example, health and accident plans and group-term life in-


surance plans were in effect at Montgomery Ward


ing to Wistert, p. 67 and 78.


as early


as 1912 accord-


These nontaxable fringe benefits were


enacted in the Code during 1954 and 1964, respectively.


36U.S., Congress, House, House Ways and Means Committee Report No.


98-432, Part II on P.L.


98-369, by Commerce Clearing House, Inc., Hou


Ways and Means Committee Print (Washinqton. I).C.: Government Printina


qeaul ation


Resul ation 1.410(bl-


account the


Senate Finance









Second, any employee who earns


ess


considered to be highly compensated unl


$35,000 per

38U.
98-432, p.


than $20,000 a calendar year is not


no employee earns mor


calendar year.


than


S., Congress, House, House Ways and Means Committee Report No.
1602.


391nitially,


the IRS had required


formation pursuant to Code Section


auto
pose.


expense


extremely detailed logs of in-


74(d)(4)


time and place of business


requesting the amount of


use, and the busine


pur-


40See Note 37.


41For an


see H.
Jones-


exce


Lent review of


phases


Chasman, ed., Deferred Compensation (Homewood,


Irwi n,


1978) and R.,J


station (Toronto: D.C.


Hansman and J.W


of deferred compensation,


Illinois:


Larrabee, Deferred Compen-


Heath and Co., 1983)


42Wistert, p.36.


43U.S. Department of the


Treasury,


Bulletin: Committee Reports and Congre


Public Law 93-406, EmpToyee


Retirement


Internal


Revenue Cumulative


ssional Record Excerpt Relating to
Income Security Act of 1974 (Wash-


ington, D.C.: Government Printing Office,


1974), p.


378.


44Revenue Ruling 56-497,


1956-2 C.B.


284; Revenue Ruling 63-180,


1963-2 C.B.


189; Revenue Ruling 68-89, 1968-1


C.B.


402.














CHAPTER 3
CAFETERIA PLANS


In general, cafeteria plans are arrangements whereby each em-


ployee has the opportunity to


spend a specified percentage of his or her


compensation on fring


benefit


lieu of


receiving a


cash payment.


cafeteria concept wa


introduced in the management


literature


in the


early


1960s.


As outlined earlier, evidence


indicates that this concept


was thought to be a viable


new employees even before t


incentive in retaining, as well

he tax laws gave preferential t


as, attracting


Treatment to its


status.1


The following sections of this chapter explain the general


nature and the current taxation of cafeteria plans.


Cafeteria Plan Features


The cafeteria plan concept embodies the following features.


Freedom of choice.


Employees participate in


selecting their


benefits according to their need


Equality between employees.


No employee or group of em-


ployees i


discriminated against with respect to fringe benefits offered


by the firmnn.


Security


The very basic benefits


life and health


insurance)


are usually offered in the plan.









Ease of choice.


The plan is as


imple as possibi


yet pro-


vides enough choices to satisfy employee needs.


The cafeteria plan concept


considered to be employee-oriented.


However, there are advantages and disadvantages to both employees and

management in the adoption of such a plan.


Consequences to Management of Cafeteria Plans


The adoption of


a cafeteria plan can have certain advantages and


disadvantages for management.


Management advantages


. Six advantages


are often


ited


as encour-


aging management's adoption of a cafeteria plan.


These


include


Direct savings of payroll


by the employee


taxes on the fringe benefits chosen


lieu of cash wages.


New benefits


introduced at


little or minimal


cost to the em-


player because the employee is the one who buys the benefit


in exchange


for other


esser


benefits.


Increased employee compensation without


increased costs due


to the employ


ees'


perception of benefits being status symbol


Increased employee awareness of the value of benefits since


the alternate

5.


lve


is cash.


Improved employee relations stemming from employee partici-


nation in the compensation process.


The ability to attract and retain qualified personnel


Management disadvantages.


Four disadvantages are often


cited a









Increased communication costs to enable the employees


understand the program detail


and to persuade employees that the program


benefits


the mutual


interests of both the employer and the employee.


Increased start-up costs in getting the basic benefit amounts


established because of adverse selection among plan participants espe-


cially in the


area of insurance.


Adverse selection occurs when there is


a disproportionate amount of bad-risk individual


individuals and the bad-risk group cannot be effectively


pooled with good-risk


excluded from


purchasing the


benefit.


in the


case


of insurance,


medical


claims


of the bad-risk group will


coverage for all


tend to drive up the cost of the insurance


individual


The eventual


detrimental


effects of the


"wrong choice"


prob-


lem where some employees may overallocate benefit coverage in one area


leaving themselves exposed without coverage in another area


(e.g.


taking


arger cash bonus


instead of obtaining adequate health insurance or


taking


larger current benefits


instead of retirement benefits).


Although the disadvantages might appear very costly,


have already addressed the above problems quite sati


some firms


sfactorily.


Consequences to Employees of Cafeteria Plans


The participation in a cafeteria plan can have certain advantages

and disadvantages for the employees.


Employee advantages.


Six advantages are often


cited encouraging


employees to DarticiDate in a cafeteria clan.


These include









Assessment of hi


her true rate of overall


compensation be-


cause cash can be taken in


lieu of benefits.


Flexibility to choose what he/she needs by avoiding unwanted


benefits.


Access to new benefits.

Increased job motivation because of participation in company


matters.


Employee disadvantages.


Three disadvantages are often cited a


discouraging employee participation in cafeteria plans.


These include


. Complexity of


choi


and the need for financial


advisement to


avoid the "wrong choice" problem.


A lock-in effect whereby the employee becomes


locked-in to


certain benefit


for at


least a year.


Distrust of management that benefits are being reduced.


The disadvantages of cafeteria plan


are not so formidable considering that employ


with respect to the employee

ees make similar choices


that affect their financial well-being outside of the employment area


that may have far more impact on their daily


lives


e.g., buying durable


good


buying a home,


investing, etc.).


Most of these example


illus-


trate a


lock-in of their choice for considerably more than one year


far as distrusting management, any employee


that participate


in a cafe-


teria plan should take the time to investigate the plan detail


For the


plan to


succeed, management must provide the employees


with information










concept can be an economically advantageous approach to compensation


management


for all


parties


involved.


Types of Cafeteria Plan


The way in which a cafeteria plan may be designed


only


limited


by the designer


s imagination because each firm has


distinct profile


of employees.


Each firm probably has a particular philosophy or program


of offering it


fringe benefits.


However, most plans may be designed


around the following three configurations.3


Mini-plan.


Instead of offering a


employees the same pack-


age of benefits, the em

specific groups such as


player designs a set of benefit packages aimed at


ingle employees, married employees with non-


working spouses, etc.


Each plan is of equivalent value.


Each employee


ects one, and only one, package.


tratively

ability and


This approach, although admini


simpler than the two plans described below, offers more flexi-


, in reality, provides the same basic security as that of the


employer's current compensation plan practices.


Core plan.


Starting with the employer


existing benefits, a


"core"


or minimum offering of these benefit


would be a required purchase


by al


emplo


yees.


The employees would have a choice of retaining their


existing


leve


of benefits or choosing


lower benefits


(down to th


spec-


ified core values) thereby accumulating credits.

then be used to purchase other benefits not incl


pmnlnvpr wnald Al n he ah


. -


These credits would


uded in the core


tn ntarrhacp anv hpnpfit' thrnunh additional










Full choice plan.


Under this arrangement,


the employee


allowed to spend a fixed percentage of


compensation on any benefit of-


fered by the firm.


This arrangement provides full


exibility without


employer responsibility for employee choices.


Legi


lative History of the


Taxation of Cafeteria Plans4


The earliest attempt to regulate the taxation of fringe benefits


offered under a cafeteria plan was through Sec

Retirement Income Security Act of 1974 (ERISA)


tion 2006 of the Employee

.5 At that time, Congress


was unsure of the treatment that


should be afforded participants


in a


salary reduction plan or a


cash or deferred profit-sharing plan.


until


1972,


the IRS allowed employees to exclude from income


any amount


contributed by an employer to such a retirement plan even


if the


source


of the fund


was an agreement by the employee to take a salary or bonus


reduction or to forego future


salary increases.


contrast,


empl oyee


contributions to an employer-maintained,


qualified retirement plan were


not tax deductible


On December 6,


IRS issued proposed regu-


nations that would have taxed employees on the employer contributions to

salary reduction plans.


When Cong


1974,


ress


addressed the issue of salary reduction plans in


it saw no difference between the substance of these plan


and that


of cafeteria plan


lars).


employees purchasing benefits with pretax


In order to more fully understand the ramifications of these


areas, Congress out a freeze on the tax statu


of all


of these


olans.


.e.


.









in existence on June


, 1974, would be included in the empl


oyee s


gross


income to the extent that the employee actually elected taxabi


benefits.


In the


case


of cafeteria plans


established after


June


, 1974, all


ployer contributions would be included in the employee's gross income to


the extent that the employee could have el


ected taxable benefits


Hence,


cafeteria plans


initiated after


June


, 1974 were governed by the


constructive


receipt doctrine.


This doctrine states that when a taxpayer


can choose between taxabi


and nontaxabh


benefits


benefit


become


taxable because availability of the


election.


Tax Reform Act of 1976


extended the above rules to employer contributions made before January 1,


1978.6


Treatment Extension Act of 1977


further extended the


to employer contribution


mad e


before January 1,


1979.


Congress enacted Code Section


19788 to establish permanent rul


125 as part of the Revenue Act of


for the taxation of cafeteria plans.


Effective for taxabi


years beginning after December 31


1978, a cafe-


teria plan had to be a written plan allowing employees to


hoose between


cash, taxabi


benefits, and nontaxable


benefits.


Both the House and


Senate versions of the bill


tipulated that the nontaxable benefits would


include only group-term life


insurance up to $50,000 of


coverage, dis-


ability benefits, accident and health benefits,


and group


legal


servi


ces.


Deferred compensation plans were not to be included in a cafeteria plan.


The nontaxable benefits chosen would not be included in the employee'


gross


income but the cash and taxable benefits chosen would be taxable


em-









The Mi


scellaneous Revenue Act of 19809 added a sentence to Code


Section 125(d)(2) allowing profit-sharing or stock bonus plans which in-


luded a qualified cash or deferred compensation arrangement (as


fied in Code Section 401(k)(2


speci-


to be included in the cafeteria plan


design.


During the years 1978-1983, taxpayers were wary in setting up


cafeteria plans for two major reasons.


First, the IRS did not propose


any regulations for interpreting Code Section 125.


Second


for at least


a decade, the entire fringe benefit area was under scrutiny with regard

to exactly which fringe benefits were to be considered nontaxable. In


1975, the Treasury circulated a draft of proposed regulations outlining


the rul


for nontaxable fringe benefits.


In 1978


, Congress imposed a


moratorium on the issuance of Treasury rulings and regulations under Code

Section 61 with respect to the income tax treatment of nonstatutory


fringe benefits.


Congress wanted more time to study the fringe benefit


area.


As mentioned above, Congress had only four statutory fringe bene-


fits, plus certain deferred compensation plans, in mind


as constituting


the nontaxable fringe benefits of a cafeteria plan.


However, Code


Sec-


tion 125(f) which was incorporated in 1978 had defined the nontaxable


benefits to be included in a cafeteria plan


as "any benefit which


is not includible in the gross income of the employee."


With the non-


statutory fringe benefit controversy still unsettled, taxpayers formu-









cafeteria plan concept.10


The IRS asserted that these types of plans


were deferred compensation devices not qualifying for tax-free benefit


treatment and inferred that both employers and empl


oyees


would be iabl


for back income taxes, penalties, and interest.


In May of 1984, the IRS issued proposed regulations for Code Sec-

tion 125 and allowed a transition period for plans that currently were


not in compliance with the Regulations.

lations insisted that the only nontaxable


In addition, the proposed regu-


benefits that could be offered


in a cafeteria plan were those benefits that were, at present


excluded


from gross income under a specific provision of the Code and were not


specifically prohibited from inclusion in a cafeteria plan.


At that


time, the eligible fringe benefits were group-term life insurance up to

$50,000 of coverage, health and accident insurance, qualified group legal

services, and dependent care assistance programs.

In essence, the IRS was tightening the rules of cafeteria plans


and was forcing a solution to the nontaxabi


fringe benefit argument by


allowing only those statutorily-excluded benefits to be part of the


cafeteria plan design.


As of yet, these proposed regulations have not


been formally approved


On July 18, 1984, President Reagan signed into law the T


Act of 1984 (TRA 84).11


changes in the cafeteria plan area.

fective on January 1, 1985. The ma


Reform


Section 531(b) of this Act was devoted to


Most of the provisions were ef-


ijor ramifications of TRA 84 were









3. Prohibition of a cafeteria plan from discriminating in favor

of a "key employee."


Addition of reporting requirements for employers.

Adoption of transitional rules for plans in existence on


February 10


, 1984 that failed the requirements of the IRS proposed regu-


1 nations.


Directing the Secretary of Health and Human Services to con-


duct a study of the effects of cafeteria plans on health care costs.


following section of this chapter examines the provisions of Code Section

125 as it is now amended.


Taxation of Cafeteria Plans12

Code Section 125(a) states that,

except as provided in subsection (b), no amount shall be included in


the gros


income of a participant in a cafeteria plan solely because,


under the plan, the participant may choose among the benefits of the
plan.


The essence of thi


statement is to preclude the constructive receipt


doctrine from coming into play (causing taxation of benefits to em-

ployees) if the Section 125 requirements are met.


The Cafeteria Plan


The cafeteria plan is defined in Code Section 125(d) in three


basic statements.


First, the plan must be a written document.


Second,


the only participants must be employees of the employer.


Third, the


participants must have the riaht to choose amona two or more benefits









plan benefits and the periods of benefit coverage;


eligibility


rules for plan part


cipation;


(3) the benefit election rules which in-


clude the time of


election,


the time for revocations, and th


time of


effective benefit coverage;


the source of plan funding


5) the


maximum amount of employer contributions per participant;


the desig-


nated plan year of operation.13

In describing the plan benefits, reference may simply be made to


other benefit plans that are already in existence (e.g


, an


existing


group


legal


services plan)


However


, any difference


in the cafeteria


plan


dollar benefit t


from any separate written plans must be disclosed.


Employees as participants.


The term "employee"


includes present


and former employees of the employer


A cafeteria plan may not be


listed for the predominant benefit of former employ


ees.


estab-


Employees of a


controlled group of business operation


are considered as employees of a


empl oyer.


I f-employed individual


are not considered as em-


ployees for purposes of a cafeteria plan.14


Spouses


and dependent


of employees are not allowed to directly


participate in a cafeteria plan through the


selection or purchase of


benefits


However,


they may indirectly participate in selecting certain


options because of employee death


Also,


they may indirectly prosper


from benefits


selected on their behalf (e.g., health insurance coverage


for an entire family or dependent care coverage)


Benefit


selection.


The plan must offer each employee the choice









Also, a provision must be included to prevent an employee from revoking

an election after the election period has passed and before the benefit


is received.15


Proposed Regulation Section 1.125-1 (Q-A 8) specific


that a participant may revoke an election after the benefit period has


started and may make a new election of benefits only in the


case


of a


change in family status (


e.g., marriage, divorce, death of a spouse or


child, birth or adoption of a child, and termination of employment of a

spouse).


Under Proposed Regulation Section 1.125-1 (Q-A 6), the plan's


funding may come from employer and employee contributions.


Employer


contributions may be voluntary or may be part of a salary reduction plan


ong as the compensation (1) has not actually or constructively been


received by the employee and (


will not


subsequently be made available


to the employees until after the benefit


Definition of Nontaxabi


selection period has ended.


Benefits


Code Section 125(f) infers that the only nontaxabi


benefits


that may be offered in a cafeteria plan are group-term life insurance

(even if it exceeds $50,000 of protection),16 accident and health insur-


ance, group legal servi


ces,


and dependent care assistance payments.


same Code Section specifically


excludes the following nontaxable fringe


benefits from inclusion in a


van pooling (Section 124)


cafeteria plan


scholarships (Section 117),


educational assistance programs


Section 127),


and miscellaneous fringe benefits (Section 132).









considered nontaxable in the Code,


then it


is nontaxabi


for cafeteria


plan purposes (e.g., accident and health premiums excluded by Code


Sec-


tion 106).


If a benefit


is nontaxabi


in the Code but specifically


prohibited from being included in a cafeteria plan


then its


inclusion in


a cafeteria plan would make it


benefits availabi


benefit


under Code Section 124


taxable (e.g., v

). If a benefit


an pooling


is taxabi


the Code,


it remains taxabi


if offered under a cafeteria plan (e.g.,


payments for home mortgage insurance.)


Nondiscrimination Standard


Code Section 125(b)


states that a cafeteria plan must not dis-


criminate in favor of highly


compensated individual


with


respect to


participation standard


and with respect to the contributions and bene-


fits of the plan.


must


If discrimination occurs,


include the employer contributions


these favored individuals


in income to the extent that they


could have elected taxable benefits under the plan.


A highly compensated


individual


(participant)


is defined in Code Section 125(e)


as one who is


an officer or a five


percent shareholder of the employer,


pensated (based on the facts and circumstances), or i


pendent of an individual


highly com-


a spouse


in one of the aforementioned three


or de-


lasses


plan that is maintained under an agreement that the Secretary finds to be

a collectively-bargained agreement between employee representatives and


one or more employers will not b

Participation standards.


'e considered di


scrimin atory.


Under Code Section 125(a)(3)


a


the samp









of employees who are officers, shareholders, or who are highly compen-


sated is not treated as discriminatory.


Thus, unlike qualified plans, no


cafeteria plan may require any employee to complete more than three years

of employment with the employer in order to be eligible for participa-


tion.


Once an employee has satisfied the employment standard and is


otherwi


eligible for entry into the plan


he/she must be permitted to


participate in the plan no later than the first day of the first plan


year subsequent to meeting the employment standard unl


ess


the employee


was separated from servi


before


uch date.


Benefits and contributions.


Under Code Section 125(c), a plan is


not discriminatory if the statutory nontaxable benefits and total bene-


(or employer contributions for these benefits) do not discriminate


in favor of highly compensated participants.


All plan participants must


be given an equal opportunity to select nontaxable benefits and the


actual benefit


selection must not be discriminatory.


Under Code Section 125(g)(2)


special rules must be mnet when a


plan provides health benefits.


A plan i


not discriminatory if the


contributions for each participant equal 100% of the benefit coverage of

the majority of highly compensated participants within the same family

size, or are at least 75% of the cost of the most expensive coverage of


any plan participant within the same family size.


In addition, any


contributions in


excess


of the above limits must bear a uniform relation-


ship to compensation.









insurance in


excess


of $50,000 for this purpose.)


If this requirement is


not met,


the key employees and highly compensated employees will


be taxed


as though they received all


taxable benefits under the plan.


Taxation of Discriminatory Plans


When a plan i


found to be discriminatory,


the highly compensated


participants or the key employees,


as the case may be, are taxed on the


employer contributions that represent the highest aggregate value of tax-


able benefits that could have been elected by these participants


in the


plan.


The employee includes the amount of these


employer contributions


as gross income for the year in which the plan year ends.


Even


if the plan is discriminatory,


highly compensated will


be taxed only on the taxable


the employees who are not


plan benefits that


they had selected.


In all


cases


where plan benefit


are taxable


, payroll


taxes will


be imposed upon the employer and the employee through the


provisions of Code Sections 3121(a)


and 3306(b).


Recordkeeping Requirements


Code Section 125(h) mandates certain reporting requirements in


accordance with Code Section 6039D.


Any employer who maintains a


teria plan during any year beginning after December


return indicating the following information:


1984 must


the number of


afe-


file a


ts em-


pl oyees


(2) the number of employees


eligible


to participate in the plan;


the number of employees part


cipating in the plan;


the total


cost









the Secretary of the Treasury may require specific information from a

select group of employers and that information must be furnished on


demand.


Code Section 6652(f) imposes a penalty of $25 per day (not to


exceed $15,000) for failure to file any information returns under Code

Section 6039D.


Transitional Rul


for Compliance


Section 531(b)(5) of the TRA 84 established two transitional


for cafeteria plans that were in existence on February 10, 1984 and


which did not comply with the proposed Treasury regulations.


These rules


were intended to give employers time to make their plans conform to the

proposed regulations without imposing retroactive penalties of prior year

income taxes, interest, and penalties on both the employer and the em-

ployee.


The general transition rule states that any plan in existence on


February 10


1984 that failed, and continued to fail


, to satisfy the


proposed Treasury regulations with respect to (1) the operational re-

quirements of the cafeteria plan rules or (2) the specific requirements


regarding the statutory nontaxabi


benefit


included within a cafeteria


plan design will not be disqualified before the later of January 1, 1985

or the date the plan modification occurred which provided the additional

benefits.


A special transitional rul


"7 FRPA" 2rrrnn lmnntc


applies to "flexible spending" and


Thaca nl nc irn nnt rli cnnl f ifi hafnro th0 la nr









after December 31, 1984, plan contributions must be fixed before the


beginning of the plan year and unused contributions


(taxabi


cash) cannot


be distributed until


the end of the plan year


The regulations state


that unused contributions may be carried over to the next succeeding plan

year.19


Section 531(b)(5


C) of the 1984 Act provides that the transi-


tional


relief will be granted for cafeteria plans that were not


in exis-


tence on February


1984 but for which employers had made a substantial


financial


commitment to implement.


For these


plans


, the plan will


considered to have been in existence on February


1984


as of


date,


the employer had incurred $15,000 of implementation costs or had


incurred more than one-half the costs of


implementing a plan


Notes


D.L.


Company," Personnel


least


Thomsen


Journal


"Introducing Cafeteria Compensation i n


56 (March 1977):


124-131


for a


list of


Your
at


eighty different fringe benefits that firms have been offering


employees.
accident,


paid workdays
birthdays. S


These range from various types of


life, health, auto,


for personal


homeowner,


travel


insurance plans


e.g.,


etc.,) and retirement plans,


, education, political


activity


"A Benefits Shopping Spree," Computer Decisions, March


1983, pp.


27-28 and "Flexible Compensation Cut


Needs," Personnel


success


60 (March-April


with cafeteria plans.


2The article by E.


1984, pp. 61-66 discu
into operation. The


sses


Wojahn,


seven


1983)


Costs and Meets


Employ


-49 for evidence of firm


"Beyond the Fringes,


firms hav


firm of Hewitt Associat


firm with 400 employees, was able
their cafeteria plan by using note


put a


a benefits


" Inc., March
cafeteria plan


consulting


to administer employee benefit


cards.


under


The Clairson International


Corporation, with 400 employees, opted to put their cafeteria plan on a


minicomputer.


Both Clairson and the Quill


Corporation (500 employees)


communicated with their employees by holding meetings, distributing note-









of adverse


medical


ance


selection is to pool different


and dental


coverage) to create


insurance policies (1


a lower risk


arrier thereby bringing the costs down.


ce" problem, a


"core" of benefits


factor for the insur-


With respect to the


"wrong


an be made mandatory


3Adapted from A. Cole, Jr.
ter Employee Relations," Personnel


exible Benefits Are a Key to Bet-


Journal


62 (January


1983)


49-53


4Since
1986, historic


the data gathered for this study were completed by


1


spring,


references have been made up to that point in time


, Congress, House, Employee Retirement


Income Security Act


of 1974


. 93-406, 93rd Cong.,


1974.


94th Cong.


. Congress, House,
1976, Section 1506.


Tax Reform Act of 1976, Pub.


94-455,


, Congress, House,


Treatment Extension Act of 1978,


Pub.


95-615, 95th Cong.,


1978, Section 5


IU.S., Congress, House,
95th Cong., 1978, Section 134(a


Revenue Act of 1978, Pub.


95-600,


, Congress, House, Mi


scellaneous Revenue Act of 1980,


Pub. L.


96-605, 96th Cong., 1980, Section 226(a).


10Some firms were using either a


balance reimbursement"


approach,


(ZEBRA) account.


employees would determine,


wages that would be set aside
charges were incurred, the em


the employee.


"flexible
Under the


in advance,


in an account


player would iss


At year-end, any remaining


spending"


or a


"zero


"flexible spending"


the sum of their pretax


for authorized expenses.


ue a reimbursement check to


cash would be


issued to the em-


ployee and included in taxable


wages.


viewed the refund feature


as unlaw
amounts


ful


in the


ense that an employee was assured of receiving


available for expense reimbursement without regard to whether the


employee actually incurred the contracted expenses.


The IRS regarded


this arrangement as a method of obtaining deferred compensation.


gres


Con-


had explicitly denied the use of most deferred compensation ar-


rangement


tered


in cafeteria plans.


except that the benefit amount wa


ZEBRA accounts were similarly adminis-


not predetermnnined.


liii.


98th Cong.,


S., Congress, House,
1984.


Tax Reform Act of 1984, Pub.


98-369,


12Since the data gathered for thi


1986


the tax


ited reflects the


study were completed by spring,


law that was in effect when the


.... T


e.


,


i


--









16The insurance protection in


under Code Section 79 but


its presence


excess


of $50,000 would be


taxable


would not disqualify the plan.


17The term "key employee"


is defined under Code Section 416(i)(1)


as an employee


who, during the


preceding plan years,


compensation in
compensation in
the employer, (


excess
excess


a fiv


percent owner with annual


current plan year, or any of the four


s (1) an offi
of $45,000, (


cer of the employer with an annual


one of ten employees


with annual


of $30,000 and owning the largest interests


percent owner of the employer


compensation in


excess


or (4


of $150,000.


a one


18Proposed Regulation Section 1.125-1

19Proposed Regulation Section 1.125-1


(0-A 11).


(Q-A


and 28).














CHAPTER 4
RESEARCH METHODOLOGY


This chapter primarily discusses the research design used to


investigate Research Questions One, Two, and Three.


Before information


on the specific research questions is addressed, the research question-

naire which is common to all research questions is discussed.


The Questionnaire


An eleven-page questionnaire was to be administered to groups of


participants in the study


Appendix A, SAMPLE QUESTIONNAIRE.)


Based on a pilot test of administering the questionnaire, each group

session was to last no more than fifty minutes with at least fifteen

minutes spent in discussing the purpose of the questionnaire and instruc-


ting the participants in completing the instrument.


In all


cases,


parti-


cipants were to be guaranteed anonymity.1

The design of the questionnaire was based upon the principles of


the Analytic Hierarchy Process (AHP).


This theory i


a reflection of how


the human mind works in solving a problem that entail


many factors and


involves choosing the best solution from among several viabi


tives.


alterna-


When a decision maker is faced with a problem involving a multi-


tude of factors, the theory suggest


that the factors be organized into









to other sets of properties that will


form other level


of factors


in the


hierarchy.


Level


are placed within the hierarchy reflecting the thought


process of working from the general


Figure 1


to th


illustrates the four-level


specific.

hierarchy for Research Ques-


tions One and Two which deal with the issues of employee motivation in

choosing fringe benefits and the actual employee fringe benefit priori-


ties, respectively.


Level


represents the goal


or the problem of the


employee to decide upon a compensation package.


Level


represent


economic and noneconomic


motivating factors that the employee considers


when making the actual


election of fringe benefits.


Levels 3 and 4


represent the actual


fringe benefits offered in a cafeteria plan but are


stated in a two-level


clustered fashion depicting a general


type of


benefit


level


3 and a specific benefit


level


Figure


illustrates the two-level


hierarchy for Research Ques-


tion


Three which focuses on a company plan for the distribution of fringe


benefits.


Level


represents the goal


or the problem of the employee to


decide upon a fringe benefits plan.


fit plan choices availabi


the mini


Level


to the employee.


, the core, and the full


represents the fringe bene-

Three of the plans namely,


choice plan, are cafeteria-type plans


and the fourth choice is the existing company plan.


The Analyti


Hierarchy Process


(AHP)


a priority theory


involves a mathematical method that,


starting from a


lower


level


in the


hierarchy, relates the impact of that


level


with respect to some or all










81










CI-



C-,


La LaE


w I-
I"~f Cla
0cC,
I-.
oa
r





-- a

E~LJO


-43 CC 0'-



'Lao


Lu O
r1 I-c Lt. Ir -L i *rr
CC of cCZ )YV


Li -\ o fIYII II~





r 4 Lr




___ cCQ Ucc

o -4
I~ -4
(/)

CDe
I->
ccw
(Cir









82














a-
r


a~o
o La-i
3" I a-i

a:
I.
at




0 0'
SI I


a C

n L j LI)

H ~Lu




a- c

r w
o Lii








a La



r









priority


next


owe r


until


grand


solution


to the


problem


achieved.


cess


begin


y having


subject


make


pairw


ompari son


between


factor


with


respect


some


or all


factor


ecide


that


on each


are i


included


pair


factors


next


given


higher


whether


level.


factor


compare


are equally


important,


or whether


one o


factor


somewhat more


important


than


other


scale of


to 5


used


to d


tingui


between


impor


tance


one factor


over


another.


(See


Appendi


SAMPLE


TIOrN-


NAIRE


, page


sample


question


see Appendi


RATING


SCALE.)


figure


subject


will


make


pairwise


comparison


between


economic


noneconomic


factor


with


respect


factor


level


--Compensation


Package.


taking


factor


pair


sub-


jects


should


able


demon


strat


consistency


only


trans


itivity


preferences


also


nten


preference.


subject


ponses


produce


reciprocal,


dominance matrix.


Saaty


proposes


eigenvector method


scaling


matrix


to extract


prin


ipal


eigen-


vector whi


when


normal i


zed,


represent


subject


priority


ranking


(priority


vector


lower


-level


factor


with


respect


to the


higher-


level


actors.


determine


consi


stency


each


subject


judgment,


prin


ipal


igenvalue,


1max,


each


matri


computed


closer


number


actors


the matrix,


better


cons









randomly generated reciprocal matrix


(called the R.I


.) of the


same


size.


The "consistency ratio"


(C.R


is C.R.


= C.I


./R.I.


A C.R. whi


than or equal to 0.10 i


considered acceptable


The above procedures and calculations


establi


h the


subj


priorities


for one


level


of factors with respect to a higher


level


factors


With multi-levels in the hierarchy, as in figure 1,


the proce-


dure of pairwise


comparisons is repeated at each subsequent


level


(i.e.,


level


with respect to level


level


4 with respect to


evel


3) and


each matrix generated is checked for consistency.


The priority vectors


of the


lowest


level


are then pooled into a priority matrix.


latter


matrix i


then postmultiplied by the priority vector (or priority matrix


of vectors) of the next higher level


. The final


result of


calculations


yields the grand solution in any deci


ion making problem using the AHP.


Research Question One


The objective of Research Question One i


the variables of COSTS, STATUS,


to investigate whether


TAX, and FINANCIAL SECURITY are important


in choosing fringe benefits given an employee


JOB CLASS, AGE, and


FAMILY


All of these variable


es, except for STATUS, were either


directly or indirectly considered by Congress when the cafeteria


laws


were enacted.

One of the basic reasons for not taxing certain fringe benefits

stems from Congress's intent to encourage the private sector to subsidize

aoods and services that the government would ultimately have to provide









is evidenced by (1)


allowing the employee to choose between cash and


other fringe benefits without jeopardi


zing the


exclusion of statutory


nontaxable benefits


choi


(2) requiring that the company plan not


discriminate in favor of officers, owner


, highly paid emplo


yees


, and key


employees.


A basic underlying assumption i


that every employee has


unique preferences as to how he/she would like to spend company funds for


personal


benefits.


to be a mental


Therefore,


process


selection of fringe benefits is seen


involving many variabi


confronting heterogeneous


individual


Treatment


Variables


Previous research has suggested that there are differences


benefit choice based on employee cl


assifications


(e.g., semi


-skilled,


professional).


The supposition is that job classification has been used


as a surrogate for educational background and income levels


pointed out by Lawler,


However


fringe benefit packages emphasizing "the differ-


ences


between


levels of organization,


. fail(s) to emphasis


ignifi-


cant differences among people at the same organic


fore


national


subjects were asked to provide their job cl


data with respect to their income


level, their total


level


There-


lification as well as

household income


level, and their educational


background


. (See Appendi


A, SAMPLE QUES-


TIONNAIRE, pages


1 and


These data were collected with possible


subordinate testing in mind.


Extensive evidence


Doints to a multitude of demographic variables









were stratified as follows:


By job


lass


ification of (a) executives,


(b) management,


(c) pro-


fessional,


killed


, and (e)


unskilled.


By age groups of


than age 26,


(b) ages 26


- 35,


(c) ages


- 45,


(d) ages 46


- 55


, and (e


ages 56 and older.


By family


of (a)


ingle employee,


(b) employee with


spouse,


(c) employee with child dependent only, and (d) employee with both spouse


and child dependent


Having the data available according to job classification affords the

possibility of comparison between my results and those of others.


Dependent Variables


It is not


lear whether tax incentives play an important part in


structuring a taxpayer-employee


investment and compensation deci


ions.


Macroeconomic studies of the tax effects on investment decisions


(i.e.,


capital


gains and tax shelters)


indicate that tax


legi


nation does impact


upon the investor, with increasing effects as wealth increases


lar studies with regard to compensation arrangements


(i.e., cash wages


and fringe benefits)


indicate that tax


incentives do influence the mix of


total


compensation for highly-paid executives,


for employees


larger


firms than in smaller ones, and for those employees under a collective

bargaining arrangement. 11

Microeconomic studies of the tax effects on investment and re-

tirement arranasments indicate that. usually. only the very affluent are









incentives.


Therefore, a


TAX variable is included in the model


assess


whether subjects perceive this to be a viable factor.


Previous research has suggested that many variabi


have a direct


bearing on the choice of a


fringe benefit package.14


A search of the


literature concerning compensation schemes and feedback from a pilot


study bring to


light the four most important variables that enter into a


benefit choice decision.


The following four choice variables were in-


eluded in the study.


Cost savings (COSTS).


Some benefits may be desirable not


only because they are available, but also, because they can be attained


at a


power cost than the employee could attain on his own regard


tax effects.


Desire for certain benefit


(STATUS).


An employee


life-


style or social


status may dictate a choice for certain benefits


cash bonus; profit sharing plan.)


Also, other benefit


(i.e.,


may become at-


tractive because of availability (


e.g., group


legal


services.)


Tax savings (TAX)


Given the above discussion, nontaxable


benefits should be preferred by employees over taxable benefits from an


economic cost-saving viewpoint, all


things being equal.


Deferred bene-


fits may be preferred to taxable benefits; other variable


may interact


to cause thi


relationship to be true


in some cases and not


in others.


Security (FINANCIAL SECURITY).


Some benefits may be desir-


because the employee feels secure in knowing that he is covered









Statistical


Procedure


Referring to the hierarchy of figure 1, each employee will


asked to make


ix pairwise comparisons of the factors in


level


with


respect to the sole factor of level

to 5--with 1 indicating that both f


The scaling process ranges from 1


actors are equally important; with 5


indicating that factor A is absolutely more important than factor B, and


so forth.


This process yields each


subject


priority vector,


V2:1/1


vector of level


compared to


level


yielding one vector stated in


proportion


, for the four dependent variabi


The statistical


procedure to test Research Question One is a


MANOVA with four response


(dependent) variables (i.e, COSTS, STATU


, TAX,


FINANCIAL SECURITY) and three


independent variables (i.e., JOB CLASS,


AGE, and FAMILY SIZE).


The independent variabi


have the following


levels:


five


levels of the job class factor (JC),


five


level


of the age


group factor (A), and four


levels of the family


factor (FS)


model


to be employed i


as follows:


Ycijkm


= Uc


+ JCci


+ Acj


+ FSck


+ (JCcAc)ij + (JCcFS


(AcFSc)jk


+ (JCcAcFSc)ijk


+ Eijkm, where


= 1,.


= 1,


,nijk,


where


ijkm


is the proportion of priority ass


m-th individual


in cell


signed by the


ijk for the c-th response


variable;

are the parameters for the c-th response var-
iable:


,Ic.


n


the effect of the iob class factor


level


= ))


= 1 ,5


-- ),


,4; m


*









(J CAc)ij


is the two way interaction effect between the job


class


factor and the age group factor for the


-th response variabi


(JCcFSc)ik


class


the two way interaction effect between the job


factor and the family


factor for the


-th response variable;


(AF


is the two way interaction effect between the age


group factor and the family
c-th response variable;


size factor for the


(JCcAcFSc)ijk


is the three way interaction
job class factor, the age gr


family


effect between the
oup factor, and the


factor for the c-th response


var-


are the vector random variable terms.


research Question One will


be tested for main effect


, any two-


way interactions, and any three-way interactions using MANOVA when the


four response (dependent)


variables are considered


simultaneously.


test statisti


to be employed,


in a SP


computer package,


Wilks'


Lambda Criterion as


follows


Wilks


where


Lambda


is the determinant of the S
products) matrix for error;


=- LH


SH +


P (sums of squares and cross


is the determinant of the SSCP matrix for the hypothesized


factor (


, JOB CLASS)


- LH


/ LH


+ ts


/ ndH)


where


is dE + dH


- (n+dH +


if n2 + dH


Ecijkm


2 4


Ir


ndK)









The appropriate test procedure i


to reject the null


hypothesis when


Wilks


Lambda Criterion exceeds the designated alpha bounds for testing.


Also, since the AHP method gives the distribution of responses


(by weights) to each dependent variable,


is reasonable to perform a


three-factor ANOVA on each of the four dependent variables.


The model


for the three-factor Anova is expressed as


Yijkm


+ JCi + Aj


+ (JC*A*FS)ijk


+ FSk


+ (JC*A)ij + (JC*FS)ik


+ Eijkm, where i


= 1,...,5


+ (A*FS)jk

= 1,...,5;


.,. ,


9**9


the response by the m-th individual


in cell


ujk.


are parameters for the response variable
.


the effect of the job cl


factor.


is the effect of the age group factor.

is the effect of the family size factor


(JC*A)ij


(JC*FS)ik


class


(A*FSjk


(JC*A*FS)ijk


the two-way interaction effect between the job
ss factor and the age group factor.


the two-way interaction effect between the job


factor and the family size factor.


is the two-way interaction effect between the age
group factor and the family size factor.


the three-way interaction effect between the job


lass factor,
ize factor.


the age group factor, and the family


Eijkm


are independent


, normally distributed error terms.


The appropriate test statistic is

F* = The annrnnriatp mpa


*UW *M *Y gI m l.


n square (e.


.. main effect of Factor A)


Yijkm


,









Research Hypothesi


The null


hypothesis


for Research Question One was stated


follows:


: There i


no difference in the ranking of


(i.e., COSTS, STATUS,


stratified a


FINANCIAL


dependent variables


ECURITY) among employees


to JOB CLASS, AGE, and FAMILY SIZE groups


With respect to the MANOVA tests


main


is expected that


effects would be shown for the JOB CLASS and FAMILY SIZE


Main effects


for the AGE variable are disputabi


significant


var-


It seems


very plausible that there be significant


interaction effects because the


variabi


demograph


, taken collectively, compliment the total s

y, for example, whether or not a benefit was


cope of employee


chosen because of


"cost savings"


and/or "security."17


With respect to the ANOVA results


made.


the following hypotheses are


hypothesized that those employees in higher job classifica-


tions should perceive the


TAX variable as most important.18


Low and


middle


income employees,


especially those with


large families,


should


perceive the COST


variable to be more important than the


TAX variable.


Economic


theory excludes high income individual


from thi


consideration


because their disposabi


income level


can take care of any benefit cost.


With respect to STATUS,


this variable should be significant only for the


higher paid employees and/or possibly older employees


Low and middle


income employees


who are young may have


substantial


obligations that


would preclude them from considering the STATU


variable


to be more im-




Full Text

PAGE 1

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