Question: Does a public agency need a cafeteria plan to offer cash in lieu?
Answer: Yes, a public agency must adopt a Section 125 cafeteria plan if the public agency wants to avoid unintended tax consequences of offering cash in lieu. Many public agencies offer a cash in lieu or opt-out payment to employees who waive agency-provided health insurance because they have other group health insurance (such as coverage through a spouse). Cash in lieu should be offered through a cafeteria plan to avoid triggering the constructive receipt doctrine. When the constructive receipt doctrine applies, the IRS could determine that employees had the choice to receive either cash in lieu or health insurance benefits and, therefore, should be taxed on the value of the cash in lieu regardless of their election. The cash in lieu payments will be considered taxable income—even if the employee does not elect to take the cash. This can result in surprise tax liabilities for employees and compliance issues for the public agency.