On September 27, 1997, the Pennsylvania Department of Revenue issued a Policy Statement ("Statement") concerning the application of the Pennsylvania personal income tax to payments for Internal Revenue Code section 125 cafeteria plans and employee welfare benefit plans. The Statement interprets "Act 7", in which the Pennsylvania Legislature amended the definition of taxable "compensation" retroactive to January 1, 1997 to exclude certain payments made pursuant to nondiscriminatory cafeteria plans, including some salary deferrals made to such plans. Prior to the enactment of Act 7, salary deferral contributions made on behalf of an employee pursuant to a cafeteria plan were subject to Pennsylvania personal income tax, although they were excluded from income for Federal income tax purposes. As amended, the relevant portion of the statutory definition of compensation reads as follows:

Significantly, the Statement treats an employee’s elective salary reduction contributions to a nondiscriminatory cafeteria plan as excludable "employer contributions", so long as

1. the amounts were not actually or constructively received by the employee,
2. the amounts were specified in a written cafeteria plan as available to the participant for the purpose of selecting or purchasing benefits under the plan or additional cash remuneration received in lieu of coverage,
3. the benefits selected are nontaxable under the Internal Revenue Code when offered under a cafeteria plan, and
4. the payments made would be nontaxable under the Pennsylvania personal income tax if made by an employer outside of a cafeteria plan, i.e., the salary reduction contributions are for medical, disability, or death benefits.

As interpreted, salary reduction contributions made on behalf of an employee to a nondiscriminatory cafeteria plan for medical benefits, disability benefits, or death benefits are no longer subject to Pennsylvania personal income tax. Similarly, employer-provided flex dollars used to purchase medical benefits, disability benefits, or death benefits are not taxable, but any cash received in lieu of benefits is taxable compensation. The Statement also confirms that contributions to a medical reimbursement account are not taxable as compensation if the amounts available for covered reimbursement cannot be cashed out or used for any other purpose during the taxable year or carried forward to any other taxable year.

The Statement emphasizes, however, the difference between Federal and Pennsylvania taxation and the fact that all federally excluded items are not necessarily sheltered from Pennsylvania tax simply because they are provided through a cafeteria plan. In that regard, contributions for benefits other than medical, disability, or death, such as dependent care coverage, are still taxable. Also, under the Statement, employee contributions to 401(k) plans remain taxable even if part of a cafeteria plan.

The Statement provides that in determining whether cafeteria plans are discriminatory, the rules of Internal Revenue Code section 125(g) apply.

The Statement begins with the general premise that the taxable compensation of employees includes the cost of employer-provided coverage under an employee welfare benefit plan. The Statement contains exceptions, however, including one for employer payments to nondiscriminatory welfare benefit plans covering hospitalization, sickness, disability or death. According to the Department of Revenue, the exception is limited to employer payments, so that amounts paid by or on behalf of self-employed individuals are subject to tax.

Welfare benefit plans are discriminatory if eligibility to participate, employer contributions, or benefits discriminate in favor of highly-compensated participants. The requirement that welfare benefit plans be nondiscriminatory in order for employer contributions to be excludable raises the issue of whether benefits like executive health insurance plans, or other plans that provide richer benefits for certain employees, are now taxable unless perhaps if provided under a cafeteria plan.

As noted above, Act 7 is retroactive to January 1, 1997. Accordingly, 1997 Forms W-2 must be prepared consistent with the change. Employers are not required, but are encouraged, to adjust withholding for the remainder of 1997 to compensate for overcollections in the first three quarters of the year. There is also a limited availability of returning overwithheld amounts not yet deposited. New withholding practices consistent with the change must be adopted as of the first payroll period ending in 1998.