Section 125. Cafeteria Plans  
 

Under Section 125 of the Internal Revenue Code, employers are allowed to establish what is referred to as a Cafeteria Plan. This plan must allow participants to choose among two or more "qualified" benefits or cash. A cash selection is taxable and qualified benefits are not. The "qualified benefits" permitted to be offered in a cafeteria plan are group- term life insurance, medical, accident, and disability benefits; group legal services; and dependent care assistance.

Here is the Code section:

Section 125
(a)      General Rule.
 

  Except as provided in Subsection (b), no amount shall be included in the gross income of a participant in a Cafeteria Plan solely because, under the Plan, the participant may choose among the benefits of the Plan.  
 
   
 
(b)      Exception For Highly Compensated Participants.
 
  (1)      Highly Compensated Participants.  
 
   
  In the case of a highly compensated participant, Subsection (a) shall not apply to any benefit attributable to a Plan Year for which the Plan discriminates in favor of  
 
  (A)      highly compensated individuals as to eligibility to participate, or  
 
     
 
  (B)      highly compensated participants as to contributions and benefits.  
 
     
 
   
  (2)      Key Employees.  
 
   
  In the case of a key employee (within the meaning of Section 416(i)(1)), Subsection (a) shall not apply to any Plan Year if the qualified benefits provided to key employees under the Plan exceed 25 percent of the aggregate of such benefits provided for all employees under the Plan. For purposes of the preceding sentence, statutory nontaxable benefits shall be determined without regard to the last sentence of Subsection (f).  
 
     
 
   
  (3)      Year Of Inclusion.  
 
   
  For purposes of determining the taxable year of inclusion, any benefit described in Paragraph (1) or (2) shall be treated as received or accrued in the taxable year of the participant or key employee in which the Plan Year ends.  
 
   
 
(c)      Discrimination As To Benefits Or Contributions.
 
  For purposes of Subparagraph (B) of Subsection (b)(1), a Cafeteria Plan does not discriminate where qualified benefits and total benefits (or employer contributions allocable to statutory nontaxable benefits and employer contributions for total benefits) do not discriminate in favor of highly compensated participants.  
 
   
 
(d)      Cafeteria Plan Defined.
 
  For purposes of this Section--  
 
  (1)      In General.  
 
   
  The term "Cafeteria Plan" means a written Plan under which--  
 
   
  (A)      all participants are employees, and  
 
     
 
  (B)      the participants may choose among 2 or more benefits consisting of cash and qualified benefits.  
 
   
     
 
   
  (2)      Deferred Compensation Plans Excluded.  
 
   
  (A)      In General. The term "Cafeteria Plan" does not include any Plan which provides for deferred compensation.  
 
     
 
  (B)      Exception For Cash And Deferred Arrangements.. Subparagraph (A) shall not apply to a profit-sharing or stock bonus Plan or rural electric cooperative Plan (within the meaning of Section 401(k)(7)) which includes a qualified cash or deferred arrangement (as defined in Section 401(k)(2)) to the extent of amounts which a covered employee may elect to have the employer pay as contributions to a trust under such Plan on behalf of the employee.  
 
     
 
  (C)      Exception For Certain Plans Maintained By Educational Institutions. Subparagraph (A) shall not apply to a Plan maintained by an educational organization described in Section 170(b)(1)(A)(ii) to the extent of amounts which a covered employee may elect to have the employer pay as contributions for post-retirement group life insurance if--  
 
   
  (i)      all contributions for such insurance must be made before retirement, and  
 
     
 
  (ii)      such life insurance does not have a cash surrender value at any time. For purposes of Section 79, any life insurance described in the preceding sentence shall be treated as group-term life insurance.  
 
   
 
(e)      Highly Compensated Participant And Individual Defined.
 
  For purposes of this Section,  
 
   
  (1)      Highly compensated participant. The term, "highly compensated participant," means a participant who is--  
 
   
  (A)      an officer,  
 
     
 
  (B)      a shareholder owning more than 5 percent of the voting power or value of all classes of stock of the employer,  
 
     
 
  (C)      highly compensated, or  
 
     
 
  (D)      a spouse or dependent (within the meaning of Section 152) of an individual described in Subparagraph (A), (B), or (C).  
 
     
 
   
  (2)      Highly compensated individual. The term "highly compensated individual" means an individual who is described in Subparagraph (A), (B), (C), or (D) of Paragraph (1).  
 
   
 
(f)      Qualified Benefits Defined.
 
  For purposes of this Section, the term "qualified benefit" means any benefit which, with the application of Subsection (a), is not includible in the gross income of the employee by reason of an express provision of this chapter (other than Section 106(b), 117, 127, or 132). Such term includes any group term life insurance which is includible in gross income only because it exceeds the dollar limitation of Section 79 and such term includes any other benefit permitted under regulations. Such term shall not include any product which is advertised, marketed, or offered as long-term care insurance.  
 
   
 
(g)      Special Rules.
 
  (1)      Collectively Bargained Plan Not Considered Discriminatory.  
 
  For purposes of this Section, a Plan shall not be treated as discriminatory if the Plan is maintained under an agreement which the Secretary finds to be a collective bargaining agreement between employee representatives and one or more employers.  
 
     
 
  (2)      Health Benefits.  
 
  For purposes of Subparagraph (B) of Subsection (b)(1), a Cafeteria Plan which provides health benefits shall not be treated as discriminatory if--  
 
   
  (A)      contributions under the Plan on behalf of each participant include an amount which--  
 
   
  (i)      equals 100 percent of the cost of the health benefit coverage under the Plan of the majority of the highly compensated participants similarly situated, or  
 
     
 
  (ii)      equals or exceeds 75 percent of the cost of the health benefit coverage of the participant (similarly situated) having the highest cost health benefit coverage under the Plan, and  
 
   
     
 
  (B)      contributions or benefits under the Plan in excess of those described in Subparagraph (A) bear a uniform relationship to compensation.  
 
   
     
 
  (3)      Certain Participation Eligibility Rules Not Treated As Discriminatory.  
 
   
  For purposes of Subparagraph (A) of Subsection (b)(1), a classification shall not be treated as discriminatory if the Plan--  
 
   
  (A)      benefits a group of employees described in Section 410(b)(2)(A)(i), and  
 
     
 
  (B)      meets the requirements of clauses (i) and (ii):  
 
   
  (i)      No employee is required to complete more than 3 years of employment with the employer or employers maintaining the Plan as a condition of participation in the Plan, and the employment requirement for each employee is the same.  
 
     
 
  (ii)      Any employee who has satisfied the employment requirement of clause (i) and who is otherwise entitled to participate in the Plan commences participation no later than the first day of the first Plan Year beginning after the date the employment requirement was satisfied unless the employee was separated from service before the first day of that Plan Year.  
 
     
 
   
  (4)      Certain Controlled Groups, Etc.. All employees who are treated as employed by a single employer under Subsection (b), (c), or (m) of Section 414 shall be treated as employed by a single employer for purposes of this Section.  
 
   
 
(h)      Cross References.
 
  For reporting and recordkeeping requirements, see Section 6039D.  
 
   
 
(i)      Regulations.
 
  The Secretary shall prescribe such regulations as may be necessary to carry out the provisions of this Section.  
 
   
 
(Added Pub. L. 95-600, Title I, Section 134(a), Nov. 6, 1978, 92 Stat. 2783, and amended Pub. L. 96-222, Title I, Section 101(a)(6)(A), Apr. 1, 1980, 94 Stat. 196; Pub. L. 96-605, Title II, Section 201(b)(2), 226(a), Dec. 28, 1980, 94 Stat. 3527, 3529; Pub. L. 96-613, Section 5(b)(2), Dec. 28, 1980, 94 Stat. 3581; Pub. L. 98-369, div. A, Title V, Section 531(b)(1)-(4)(A), July 18, 1984, 98 Stat. 881, 882; Pub. L. 98-611, Section 1(d)(3)(A), Oct. 31, 1984, 98 Stat. 3177; Pub. L. 98-612, Section 1(b)(3)(B), Oct. 31, 1984, 98 Stat. 3181; Pub. L. 99-514, Title XI, Section 1151(d)(1), Title XVIII, Section 1853(b)(1), Oct. 22, 1986, 100 Stat. 2504, 2870; Pub. L. 100-647, Title I, Section 1011B(a)(11)-(13), 1018(t)(6), Title IV, Section 4002(b)(2), Title VI, Section 6051(b), Nov. 10, 1988, 102 Stat. 3484, 3485, 3589, 3643, 3696; Pub. L. 101-140, Title II, Section 203(a)(1), (3), (b)(2), Nov. 8, 1989, 103 Stat. 830, 831; Pub. L. 101-239, Title VII, Section 7814(b), Dec. 19, 1989, 103 Stat. 2413; Pub. L. 101-508, Title XI, Section 11801(c)(3), Nov. 5, 1990, 104 Stat. 1388-523; Pub. L. 104-191, Title III, Section 301(d), 321(c)(1), 110 Stat. 1936.)