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SECTION 125 CAFETERIA PLANS

                                                                                   Employers’ Tax Saving Chart

Explanation of the chart above.  If an employee contributes $200 / month to this plan he/she will receive about $250, his/her employer will see about $240 in savings by not having to make matching tax contributions.

Answers to Frequently Asked Questions on Section 125 Cafeteria Plans

   What is a Section 125 cafeteria plan?  A Section 125 cafeteria plan, or simply a cafeteria plan, is an Employee benefit plan established by an Employer which allows each Employee to select certain benefits from a menu of benefit options.  The Employee's cost for the selected benefits is paid on a pretax basis.  IRS Section 125 Plans were introduced by the Revenue Act of 1978.

   What are the types of Section 125 cafeteria plans?  There are three (3) types of Section 125 cafeteria plans.  They are generally called:

    1.      Premium Only Plan.

    2.      HSA (Health Spending Account).

    3.      Combination of #1 and #2.

   Why is it called a cafeteria plan or a Section 125 cafeteria plan? It is called a cafeteria plan because Employees have the opportunity to select options from a menu of benefits, just as they can select food items in a cafeteria.

It is referred to as a Section 125 cafeteria plan because Internal Revenue Code Section 125 allows Employers to offer benefits under a cafeteria plan on a pretax basis. Section 125 was added to the Internal Revenue Code by the Revenue Act of 1978.

What are “pretax benefits" under a cafeteria plan? A benefit is a “pretax  benefit” under a cafeteria plan if the Employee’s cost for the selected benefit is paid from the Employee's salary before taxes are calculated. The effect of providing pretax benefits is to reduce the Employee's taxes, which usually results in more take-home pay. This includes FICA, federal taxes, and most state taxes.

   Is it legal to offer benefits on a pretax basis under a cafeteria plan? Yes, Internal Revenue Code Section 125 allows the Employer to adopt a cafeteria plan. Section 125 also allows the Employee to sign a Salary Reduction Form, which authorizes the Employer to deduct the cost per pay period for benefits selected, by the Employee from the plan menu.

   Is there a link on the Internet that shows how these calculations work? Yes, you can go to: http://www.dinkytown.net/java/Payroll125.html#calc to see how the calculation works.

   Why should the Employer establish a cafeteria plan?  An Employer should establish a cafeteria plan if Employees contribute towards the cost of group health coverage, group term life coverage or other medical / sickness / accident / disability coverages and benefits. 

What types of benefits may be offered under a cafeteria plan? Generally only “qualified benefits” may be offered.  Qualified benefits consist of one or more of the following: Health Benefits, Accident Benefits, Adoption Assistance, Dependant Care Assistance, Group-Term Life Insurance Coverage and Health Savings Accounts (HSAs).  

Are Employee Social Security benefits affected by reducing taxes under a cafeteria plan? Yes, but the effect is negligible.  Since the Employee's taxable income is reduced, thereby reducing FICA or Social Security taxes.  Future Social Security benefits may be reduced slightly to reflect the Employee's lower taxable salary.

   What is a Plan Year and may the plan have a short Plan Year as the first Plan Year?  A Plan Year is any period of twelve months that the Employer selects.  All plan records must be kept on the basis of the Plan Year.  The Plan Year also serves as the period of time for which an Employee's benefit election must remain in effect. Many times the Plan Year coincides with the calendar year.  However, it may also make sense for the Plan Year to coincide with the contract year of the Employer's group health program since this is when rate increases typically go into effect.  In almost all cases, it is necessary for the first Plan Year to be a short Plan Year beginning on the effective date of the plan and ending on the last day of the Plan Year.

May a participating Employee change his or her selection of qualified benefits under a cafeteria plan during the year?  Generally, qualified benefits, which are selected during the election period, may not be changed and must remain in effect for the entire Plan Year.  However, the law allows an exception if an Employee has a “qualified change in status”.  A qualified change in status includes marriage, divorce, death of a spouse or child, birth, adoption or placement for adoption of a child or a change in employment status for a family member that affects coverage under an Employer-sponsored plan.  If one of the described changes in status occurs, the Employee may change his or her selection of qualified benefits under the plan as long as the change is consistent with the change in family status and, if applicable, a change in coverage under another Employer-sponsored plan.

May the Employee select a benefit which is not designated in the cafeteria plan?  No, the plan requires that Employees select among the qualified benefits, which are available under the plan.

How does an Employee benefit by participating in a cafeteria plan?  The Employee benefits when he or she elects to pay for certain benefits with pretax dollars.  This election creates a tax savings for the Employee which he or she can receive in either higher take-home pay or in additional benefits.

Does the Employer benefit by offering a cafeteria plan? Yes, just as the Employee’s taxable salary is reduced by the cost of the qualified benefits which are chosen, the Employer's taxable payroll is also reduced.  This results in reduced FICA (Social Security taxes) and FUTA (Federal Unemployment taxes).  The reduced payroll expenses make it advantageous for the Employer to offer a cafeteria plan to Employees.

Why should an Employee participate in a cafeteria plan?  In addition to the tax savings, the Employee is allowed to assemble a package of benefits which is more meaningful to his or her personal situation.

Are there any “nondiscrimination" rules that apply to cafeteria plans? Yes, a cafeteria plan may not discriminate in favor of highly compensated Employees.  This means that the Employer may not favor highly compensated Employees with respect to eligibility to participate in the plan or contributions and benefits under it.  Furthermore, no more than 25 percent of the tax-free benefits under the cafeteria plan may go to “key Employees”.  Since the “benefit” under the Premium Only Plan is insurance coverage, no more than 25 percent of the total premiums under the cafeteria plan may be attributable to key Employees.

Are there any filing requirements that apply to cafeteria plans?  Generally, no. A cafeteria plan is a fringe benefit plan under Section 6039D of the Internal Revenue Code. Prior to 2002, this meant an Employer sponsoring a cafeteria plan was required to file an annual report (Form 5500) each year.  The requirement was satisfied by completing and filing portions of Form 5500 and Schedule F.  With the issuance of Notice 2002-24, however, the IRS suspended the annual Form 5500 reporting requirement for cafeteria plans, except in some cases where the cafeteria plan contains a health flex spending account.  Since the Employer’s Section 125 Premium Only Plan does not contain a health flex spending account, it is not required to file a Form 5500.

Form 5500 may still be required, however, for one or more of the benefit plans offered under the cafeteria plan, depending on the nature of the benefit and whether the benefit plan is a welfare benefit plan under the Employee Retirement Income Security Act of 1974 (commonly referred to as ERISA). If the Employer maintains other tax-qualified programs such as pension, profit sharing or 401(k) plans; the Employer should already be familiar with these filing requirements.  It is may be your responsibility to prepare and file Form 5500.  This is the Employer’s responsibility.

Under what circumstances would this cafeteria plan have to comply with the privacy regulations promulgated by the Department of Health and Human Services pursuant to the Health Insurance Portability and Accountability Act?  The privacy regulations under the Health Insurance Portability and Accountability Act, also known as “HIPAA”, require group health plans to maintain the privacy of certain medical information, known as “protected health information” or “PHI”.  Only group health plans defined under the privacy regulations are required to comply.  The Office of Civil Rights in the United States Department of Health and Human Services has provided the following guidance regarding whether a cafeteria plan falls within the type of plan required to comply with the privacy regulations: a ‘group health plan’ is a covered entity under the Privacy Rule and the other HIPAA, Title II, Administrative Simplification standards.  A ‘group health plan’ is defined as an ‘employee welfare benefit plan,’ as that term is defined by the Employee Retirement Income Security Act (ERISA), to the extent that the plan provides medical care. See 42 USC 1320d(5)(A) and 45 CFR

160.103. Thus, to the extent that a flexible spending account or a cafeteria plan meets the definition of an employee welfare benefit plan under ERISA and pays for medical care, it is a group health plan, unless it has fewer than 50 participants and is self-administered. Employee welfare benefit plans with fewer than 50 participants and that are self-administered are not group health plans.  Flexible spending accounts and cafeteria plans are not excluded from the definition of ‘health plan’ as accepted benefits. See 45 CFR 160.103, paragraph (2)(i) of the definition of ‘health plan’.

The guidance provided by the Office of Civil Rights does not specifically address the applicability of the privacy regulations to a premium only type of cafeteria plan. In some cases, a cafeteria plan that helps pay the premiums for a self-insured or fully-insured group health plan has been considered to be a part of the group health plan for purposes of ERISA. Consequently, in the event a cafeteria plan would be used to pay the premiums for a self-insured or fully insured group health plan, the privacy regulations would apply to the premium only cafeteria plan to the same extent it applies to the particular self-insured or fully insured group health plan.  Accordingly, a “Privacy Policy” has been included in the Premium Only Plan to address situations where the Plan is used as a funding vehicle for an underlying benefit that is required to comply with the HIPAA privacy requirements.

As with all business matters with legal or tax implications, if tax or legal advice or expert assistance is required, you are recommended to seek and consult a competent professional prior to implementing any Section 125 plan.

Is there an IRS publication that addresses cafeteria plans?  Yes, Publication 15-B Rev. February 2007.

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