Most businesses are doing what they can to cut costs during these challenging times. Targeted costs can include certain employee fringe benefits. At the same time, valued employees — some of whom may be working in high-risk situations — want to be rewarded for their services at the lowest possible tax cost.
One practical solution to this dilemma is to provide flexibility with a cafeteria plan. Employees choose the benefits they want and need and decline the ones they don’t. As a result, employers pay only for selected benefits.
Setup and Administration
How do you set up a cafeteria plan and administer it? Here are some common questions — and answers — about cafeteria plans.
Q: What requirements must my plan meet?
A: To qualify for favorable tax treatment, your cafeteria plan must be written and maintained in accordance with Section 125 of the tax code and applicable regulations. It you follow the rules, participants should qualify to receive benefits on a pretax basis. Employees must be able to choose between at least one taxable benefit, such as cash, and one tax-exempt benefit.
Tax-exempt benefits that can be offered through your Section 125 cafeteria plan include:
- Accident and health benefits (but not Archer Medical Savings Accounts or long-term care insurance),
- Adoption assistance,
- Dependent care assistance,
- Group-term life insurance coverage, and
- Health Savings Accounts (HSAs), including distributions used to pay long-term care services.
Your written plan must specifically describe all benefits and establish rules for eligibility and elections.
Q: Who’s eligible to receive benefits?
A: Cafeteria plan benefits are available to employees who choose to participate. But benefits may be extended to employees’ spouses and dependents. Former employees may also be covered, but a cafeteria plan can’t exist primarily for them.
Q: Are cafeteria plan contributions subject to income tax?
A: Usually, contribution amounts are deducted from employee paychecks on a pretax basis, pursuant to a salary reduction agreement. Salary reduction contributions are not actually or constructively received by the participant. Therefore, contributions aren’t subject to federal income tax.
Q: Are contributions subject to payroll taxes?
A: Similar to federal income tax, qualified benefits offered in a cafeteria plan aren’t subject to FICA, FUTA, Medicare tax or income tax withholding. However, group-term life insurance with more than $50,000 coverage is subject to Social Security and Medicare taxes (but not FUTA tax or income tax withholding) even if it’s provided as a qualified benefit in a cafeteria plan.
Adoption assistance benefits provided in a cafeteria plan are subject to Social Security, Medicare and FUTA taxes, but not income tax withholding. If an employee elects to receive cash instead of a qualified benefit, this compensation is subject to all payroll taxes.
Q: How do these plans differ from flexible spending arrangements?
A: A flexible spending arrangement (FSA) is a form of a cafeteria plan funded by salary reduction. It reimburses employees for expenses incurred for certain qualified benefits. Specifically, an FSA may be offered for dependent care assistance and health care expenses. Unlike a cafeteria plan, contributions to a healthcare FSA are limited to $2,750 and $5,000 for a dependent care FSA. A “use-it-or-lose-it” rule applies to FSAs. Unused funds in the account are forfeited at the end of the year, but an employer may allow a grace period of up to 2½ months or an annual carryover of $500.
Q: What happens if dependent care benefits exceed the annual statutory limit?
A: The maximum exemption for dependent care benefits is $5,000 a year, or the earned income of the employee or his or her spouse. The total dependent care benefits your organization pays to the employee or that are incurred on the employee’s behalf (including amounts from a Section 125 cafeteria plan) are reported on Form W-2. Any amount over $5,000 is included in wages.
Q: Can a cafeteria plan make advance reimbursements for medical expenses?
A: No. Employees can only be reimbursed for allowable, documented expenses incurred during the plan year, after the expenses have been substantiated.
Q: Can business owners benefit from cafeteria plans?
A: Generally, owner-employees may participate, but special rules apply to other owners. For example, sole proprietors can’t directly participate in a cafeteria plan. But they may legitimately employ their spouse and offer the spouse the benefits of the plan. In such cases, the employer must ensure that the plan is offered on a nondiscriminatory basis.
Partnerships operate much like a sole proprietorships. Although partners can’t directly participate in their company’s cafeteria plan, they may employ a spouse who can receive benefits. A more-than-2% shareholders of S corporations can’t participate in the plan — neither can his or her spouse or dependents, even if they’re employed by the company.
Get Professional Assistance
These FAQs offer only a brief overview of cafeteria plans. The plans are complex, so it’s important to talk to a professional advisor if you have questions specific to your organization and need help setting up a plan.