Section 125 Cafeteria Plans – What’s Nondiscrimination?

Section 125 Cafeteria Plans gives employers the opportunity to offer their employees a variety of health care benefits with the deductions made pre-tax. That is, the employees’ premiums for various insurance coverage are deducted from his taxable income, thereby lowering his Federal withholding, FICA tax, and Medicare taxes. The employer saves on his share of those taxes, too, and that’s what makes cafeteria plans so attractive.

But the IRS, as always, is very sensitive to the potential to abuse any benefit. With most employer-offered benefits, such as pensions and tax-sheltered annuities, the IRS frowns on any effort to exclude the average employee from the plan, or to offer the bulk of plan benefits to the upper echelon of the organization. That is why nondiscrimination rules are set. And the IRS Section 125 has its own set of parameters for nondiscrimination.

First, a cafeteria plan should not favor “highly compensated” employees. According to IRS rules, highly compensated employees are 1)officers; 2)shareholders with more than 5% of the employer’s stock; 3)an employee who is highly compensated based on the facts and circumstances; and 4)a spouse or dependent of any of the individuals in the other categories mentioned above.

Second, a cafeteria plan should not favor “key” employees. And who is a key employee? The IRS defines one as a. an officer receiving a gross annual compensation of over $160,000; b. an employee who also owns at least 5% of the company; and, c. an employee owning at least 1% of the business and who receives a gross annual income of over $150,000.

According to IRS Publication 15, if the cafeteria plan favors either of these classes of employees, you will have to include in (tack onto) their taxable wages the value of the taxable benefits they could have selected. The increase in taxable wages would also translate to higher payroll taxes for the employer to pay . It also means that it applies even if the favored employee doesn’t take advantage of the benefits.

Your plan “favors” these groups if more than 25% of the nontaxable benefits for all employees under the plan go to these employees. If the plan is offered through a collective bargaining agreement, however, it is presumed not to favor highly compensated or key employees.

So, if you’re offering a cafeteria plan, you must make sure that 1)all employees have access to the plan; and 2) all employees have access to the same benefit types and amounts under the plan.

The rules of the IRS code also mandates employers to have their Section 125 plans undergo testing for compliance with nondiscrimination rules at the end of each plan year. That is, if your plan runs from January 1 to December 31, you need to be in compliance on December 31 (but really, you should comply all year round, and not just on one day).

Conclusion. A Section 125 Cafeteria Plan is a great benefit for employees, but the administrative rules can trip up unsuspecting employers. Watch your plan and IRS rules for compliance. If you are time constrained or don’t know where to start, then a tax professional or legal consultant can assist you in sorting out your responsibilities as plan sponsor.

Give us a visit at http://taxfreepremiums.com to know you can be in compliance with your cafeteria plan. You can also find a tax savings calculator that can help you determine just how much you’ll be able to save with a Section 125 POP Plan.

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