Sec 125 Cafeteria Plans

Section 125 - Cafeteria Plans

The following is information about the tax advantages of offering a cafeteria plan to your employees and for a description of the different types of cafeteria plans available for adoption by your company. This article describes the basic nature of such plans, the tax advantages that they can provide, and the types of plans available.

Overview. Cafeteria plans may be the most attractive way of providing certain benefits to employees. Each employee may choose between receiving cash and receiving one or more qualified benefits offered on a “menu.” Thus, workers may match benefits to their own needs and priorities. A plan can be as simple or as complex as the employer wants, ranging from a plan that allows only salary deferrals to pay the employee portion of health insurance, to one offering an extensive menu of benefits.

You can deduct your contributions to a cafeteria plan on the employee benefit programs line of your tax return.

Note that special rules apply to the operation of a cafeteria plan where an employee takes leave under the Family and Medical Leave Act.

Types of Plans. A cafeteria plan allows employees to reduce their salaries and to use the forgone amount to purchase on a pre-tax basis, benefits not fully subsidized by the employer. Thus, as the employee's salary is reduced, so is his income tax liability. Even with expenses that otherwise may be deductible, such as medical expenses, a salary reduction agreement can be advantageous if a floor on deductibility would otherwise apply. As explained below, a cafeteria plan can offer insurance options such as health, disability, or group-term life insurance.

A cafeteria plan also may include one or more reimbursement accounts, i.e., flexible spending arrangements. Under these plans, cash that is foregone by the employee, through salary reduction or otherwise, is credited to a bookkeeping account maintained by the employer that the employer draws upon to reimburse employees for uninsured medical or dental expenses or for dependent care expenses. Special rules apply to health flexible spending arrangements. Many plans offer both insurance coverage and reimbursement accounts.

Requirements. A cafeteria plan must comply with basic requirements established by the specific Code section dealing with cafeteria plans, as well as any section of the Code prescribing rules applicable to the particular benefit being offered. A cafeteria plan, including a flexible spending arrangement, must be in writing and nondiscriminatory. In addition, a cafeteria plan generally may not include deferred compensation as an option, although it may include as a benefit option, the right to make contributions to a qualified cash or deferred arrangement (CODA). CODA deferrals that are made through a cafeteria plan, like regular CODA deferrals, are subject to Social Security taxes. Certain post-retirement life insurance plans maintained by educational institutions can be offered through a cafeteria plan even though they provide for deferred compensation.

Qualified benefits. A cafeteria plan may offer any qualified benefit other than scholarships and fellowship grants, educational assistance programs, medical savings accounts, long-term care insurance, and certain fringe benefits including no-additional-cost services, employee discounts, qualified moving expense reimbursements, and qualified transportation fringes. Qualified benefits include any other employer-provided welfare benefits that your employees are allowed to exclude from their income because of specific provisions of the law. Generally, qualified benefits include accident or health plans, dependent care assistance benefits, group-term life insurance, and certain medical reimbursements. The cost of group-term life insurance in excess of $50,000, and employer-provided dependent group-term life insurance also may be provided even though they are includible in gross income. Vacation days may be included as benefits but only if the plan precludes a participant from using or “cashing out” unused elective vacation days in a later year.

Qualified benefits under a cafeteria plan are not subject to social security, Medicare, and federal unemployment taxes, or income tax withholding. If an employee elects to receive cash instead of any qualified benefit, it is treated as wages subject to all employment taxes.

Inclusion of impermissible benefits in a cafeteria plan will cause such benefits to be treated as taxable benefits under the plan and the cafeteria plan as a whole will be prevented from qualifying under the Code.

An employee's election between cash and certain qualified benefits is irrevocable during the period of coverage except for certain changes in status. Unless actually elected, the fact that cash or certain taxable benefits are available under the plan does not cause an employee to be treated as having received the cash or taxable benefit.

All participants in a cafeteria plan must be employees - either current or former employees. In addition, a cafeteria plan can pay benefits to spouses and other beneficiaries of employees but such spouses and other beneficiaries may not participate in the cafeteria plan.

Nondiscrimination rules. If, in any plan year, your cafeteria plan discriminates in favor of highly compensated individuals as to eligibility to participate in the plan or as to plan contributions or benefits, highly compensated participants are taxed on the amount of the taxable benefits that could have been elected.

An individual or participant is highly compensated if he or she:

1) is an officer;

2) is a 5% owner of the employer

3) has compensation in excess of $90,000 (indexed for inflation); or

4) is a spouse or dependent of an officer, a 5% shareholder, or a highly compensated employee.

Nontaxable benefits to key employees. If your plan provides nontaxable benefits to “key employees” that are more than 25% of the total of the nontaxable benefits provided for all employees under the plan, key employees must include in income the value of the benefits that could have been elected. Key employees are those who during the plan year or any of the previous four plan years were:

1) officers with compensation over a certain dollar amount;

2) 5% owners of the employer; or

3) 1% owners of the employer with annual compensation over $150,000.

Collective bargaining agreement. If your plan is maintained under a collective bargaining agreement, it is not treated as discriminatory.

Reporting requirements. If you, as an employer, maintain a cafeteria plan, you are required to keep complete records showing:

1) the number of your employees;

2) the number of your employees eligible to participate in your plan;

3) the number of your employees participating in the plan;

4) the total cost of your plan for the tax year;

5) your name, address, and taxpayer identifying number (TIN); and

6) the type of business you are engaged in.

We hope that this article has provided you with background information that will help guide you in determining whether your company should offer a cafeteria plan and, if so, what type of plan would be most appropriate