hed on May 7, 1984,
December 31, 1984, March 7, 1989, November 7, 1997 and March 23, 2000. In general,
these proposed regulations would affect employers that sponsor a cafeteria plan,
employees that participate in a cafeteria plan, and third-party cafeteria plan
administrators.


DATES: Written or electronic comments must be received by November 5, 2007.
Outlines of topics to be discussed at the hearing scheduled for November 15, 2007, at
10 a.m., must be received by October 25, 2007.
ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-142695-05), room 5203,
Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, DC
20044. Submissions may be hand delivered Monday through Friday between the hours

2
of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-142695-05), Couriers Desk, Internal
Revenue Service, 1111 Constitution Avenue, NW., Washington, DC or sent
electronically via the Federal eRulemaking Portal at
www.regulations.gov
(IRS REG-
142695-05). The public hearing will be held at the IRS Auditorium, Internal Revenue
Building, 1111 Constitution Avenue, NW, Washington, DC.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Mireille T. Khoury at (202) 622-6080; concerning submissions of comments, the hearing,
and/or to be placed on the building access list to attend the hearing, Oluwafunmilayo
Taylor of the Publications and Regulations Branch at (202) 622-7180 (not toll-free
numbers).
SUPPLEMENTARY INFORMATION
Paperwork Reduction Act

The collections of information contained in this notice of proposed rulemaking
have been submitted to the Office of Management and Budget for review in accordance
with the Paperwork Reduction Act of 1995 (44 U.S.C. 3507(d)). Comments on the
collections of information should be sent to the Office of Management and Budget,
Attn: Desk Officer for the Department of Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue Service, Attn: IRS
Reports Clearance Officer, SE:W:CAR:MP:T:T:SP, Washington, DC 20224. Comments
on the collections of information should be received by October 5, 2007. Comments are
specifically requested concerning:


Whether the proposed collections of information is necessary for the proper
performance of the functions of the Internal Revenue Service, including whether the

3
information will have practical utility;

The accuracy of the estimated burden associated with the proposed collection of
information;

How the quality, utility, and clarity of the information to be collected may be
enhanced;

How the burden of complying with the proposed collections of information may be
minimized, including through the application of automatic collection techniques or other
forms of information technology; and

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

The collection of information in this proposed regulation is in §1.125-2 (cafeteria
plan elections); §1.125-6(b)-(g) (substantiation of expenses), and §1.125-7 (cafeteria
plan nondiscrimination rules). This information is required to file employment tax
returns and Forms W-2. The collection of information is voluntary to obtain a benefit.
The likely respondents are Federal, state or local governments, business or other for-
profit institutions, nonprofit institutions, and small businesses or organizations.

Estimated total annual reporting burden: 34,000,000 hours.

Estimated average annual burden per respondent: 5 hours.

Estimated annual frequency of responses: once.

An agency may not conduct or sponsor, and a person is not required to respond
to, a collection of information unless it displays a valid control number assigned by the
Office of Management and Budget.

Books or records relating to a collection of information must be retained as long

4
as their contents may become material in the administration of any internal revenue law.
Generally, tax returns and tax return information are confidential, as required by 26
U.S.C. 6103.
Background

This document contains proposed Income Tax Regulations (26 CFR Part 1)
under section 125 of the Internal Revenue Code (Code). On May 7, 1984, December
31, 1984, March 7, 1989, November 7, 1997, and March 23, 2000, the IRS and
Treasury Department published proposed amendments to 26 CFR Part 1 under section
125 in the Federal Register (49 FR 19321, 49 FR 50733, 54 FR 9460, 62 FR 60196
and 65 FR 15587). These 1984, 1989, 1997 and 2000 proposed regulations are hereby
withdrawn. Also, the temporary regulations under section 125 that were published on
February 4, 1986 in the Federal Register (51 FR 4318) are being withdrawn in a
separate document. The new proposed regulations that are published in this document
replace those proposed regulations.
Explanation of Provisions
Overview
The new proposed regulations are organized as follows: general rules on
qualified and nonqualified benefits in cafeteria plans (new proposed §1.125-1), general
rules on elections (new proposed §1.125-2), general rules on flexible spending
arrangements (new proposed §1.125-5), general rules on substantiation of expenses for
qualified benefits (new proposed §1.125-6) and nondiscrimination rules (new proposed
§1.125-7). The new proposed regulations, new Proposed §§1.125-1, 1.125-2, 1.125-5,
1.125-6 and §1.125-7, consolidate and restate Proposed §1.125-1 (1984, 1997, 2000),

5
§1.125-2 (1989, 1997, 2000) and §1.125-2T (1986). Unless otherwise indicated,
references to new proposed regulations or these proposed regulations mean the
proposed section 125 regulations being published in this document.
The new proposed regulations reflect changes in tax law since the prior
regulations were proposed, including: the change in the definition of dependent (section
152) and the addition of the following as qualified benefits: adoption assistance (section
137), additional deferred compensation benefits described in section 125(d)(1)(B), (C)
and (D), Health Savings Accounts (HSAs) (sections 223, 125(d)(2)(D) and 4980G), and
qualified HSA distributions from health FSAs (section 106(e)). Other changes include
the prohibition against long-term care insurance and long-term care services (section
125(f)) and the addition of the key employee concentration test in section 125(b)(2).

The prior proposed regulations, §§1.125-1 and 1.125-2, provide the basic
framework and requirements for cafeteria plans and elections under cafeteria plans.
The prior proposed regulations also outlined the most significant rules for benefits under
a health flexible spending arrangement (health FSA) offered by a cafeteria plan the
requirement that the maximum reimbursement be available at all times during the
coverage period (the uniform coverage rule), the requirement of a 12-month period of
coverage, the requirement that the health FSA only reimburse medical expenses, the
requirement that all medical expenses be substantiated by a third party before
reimbursement, the requirement that expenses be incurred during the period of
coverage, and the prohibition against deferral of compensation (including the use-or-
lose rule). The prior proposed regulations also provided guidelines for dependent care
FSAs, and the application of section 125 to paid vacation days offered under a cafeteria

6
plan. These remain substantially unchanged in the new proposed regulations, with
certain clarifications. Finally, the prior proposed regulations included a number of Q &
As addressing transitional issues relating to the enactment of section 125, as well as the
application of the now-repealed section 89 (special nondiscrimination rules with respect
to certain employee benefit plans). These provisions are omitted from the new
proposed regulations.
I.
New Proposed §1.125-1--Qualified and nonqualified benefits in cafeteria plans
Section 125 exclusive noninclusion rule

Section 125 provides that, except in the case of certain discriminatory benefits,
no amount shall be included in the gross income of a participant in a cafeteria plan (as
defined in section 125(d)) solely because, under the plan, the participant may choose
among the benefits of the plan. The new proposed regulations clarify and amplify the
general rule in the prior proposed regulations that section 125 is the exclusive means by
which an employer can offer employees a choice between taxable and nontaxable
benefits without the choice itself resulting in inclusion in gross income by the employees.
When employees may elect between taxable and nontaxable benefits, this election
results in gross income to employees, unless a specific Internal Revenue Code (Code)
section (such as section 125) intervenes to prevent gross income inclusion. Thus,
except for an election made through a cafeteria plan that satisfies section 125 or
another specific Code section (such as section 132(f)(4)), any opportunity to elect
among taxable and nontaxable benefits results in inclusion of the taxable benefit
regardless of what benefit is elected and when the election is made. This interpretation
of section 125 is consistent with the legislative history of section 125. The legislative

7
history begins with the interim ERISA rules for cafeteria plans:
Under ERISA, an employer contribution made before January 1, 1977, to a
cafeteria plan in existence on June 27, 1974, is required to be included in an
employees gross income only to the extent that the employee actually elects
taxable benefits. In the ca