Many small business owners provide fringe benefits to their employees by establishing a Section 125 Plan. Also called a cafeteria plan, a Section 125 plan affords tax advantages to businesses and their employees. The tax savings enable employers to provide benefits at a reduced cost.
Section 125 Plan
A Section 125 Plan is a written plan that allows participants to receive certain benefits, called qualified benefits, on a pretax basis. Its name derives from Title 26, Section 125 of the United States tax code, which establishes the rules employers must follow when operating a cafeteria plan.
An employer may sponsor a cafeteria plan if it employs workers who are subject to federal income taxes. The employer may be a sole proprietorship, corporation, partnership, LLC, or a government entity, as long as it employs an average of 100 employees or less for at least two years. Only employees, their spouses, and their dependents may participate in a plan. Independent contractors, partners, members (of an LLC), and individuals who own more than 2% of an S corporation aren't eligible.
How the Plans Work
Under a Section 125 Plan, employees pay for benefits via a payroll deduction. Because the money deducted from workers' pay isn't subject to taxes (federal, state, local, Medicare, or Social Security), employees retain a greater portion of their earnings. Employers save money since the contributions they make to pay premiums are also exempt from taxes.
For a plan to qualify as a cafeteria plan, it must allow employees to choose among two or more benefits, one of which must be taxable (such as cash). The other benefit must be a qualified benefit.
Employees enrolled in cafeteria plans can make elections once a year. Mid-year elections may be permitted if workers experience a life event such as marriage, divorce, or a change in employment. However, on May 12, 2020, the IRS announced temporary changes to section 125 cafeteria plans to allow people to make mid-year changes to their plans to accommodate their changing finances as a result of the public health crisis and economic downturn.
Once an employer has created a benefit plan, it can administer the plan itself or hire a third-party administrator to oversee it. The tax benefits employers receive from the plan will likely offset some (or all) of the administration costs.
Under Section 125 of the U.S. tax code, employees may use pre-tax dollars to pay for qualified benefits only. Qualified benefits include the following:
- Group health benefits
- Dental and vision benefits
- Disability and life insurance
- Flexible spending accounts
- Dependent care assistance programs
- Health savings accounts
Examples of benefits that aren't considered qualified benefits include educational assistance, employer-provided cellphones, employee discounts, meals, and retirement planning services.
The IRS rules regarding Section 125 benefit plans are explained in detail in Publication 15-B, the Employers Tax Guide to Fringe Benefits.
Types of Plans
When establishing a cafeteria plan, employers have four options.
- Premium payment plan: Employees pay their portion of the premium for qualified benefits with pretax dollars. Some plans allow workers who opt out of the plan to receive extra pay on a taxable basis.
- Flexible health or dependent care spending plan: Employees use pretax dollars to pay for healthcare expenses (up to $2,750 in 2021) or the cost of caring for a dependent (up to $10,000 in 2021).
- Full cafeteria plan: The employer makes a contribution that employees can use to buy qualified benefits. If the contribution doesn't cover all the premiums, employees can use a tax-exempt salary deduction to pay the balance.
- Simple plan: Designed for small businesses with 100 employees or less. Has more lenient non-discrimination requirements than other plans.
To receive the tax benefits of a cafeteria plan, employers must comply with federal requirements. For instance, the benefit plan must be in writing. The plan must describe the benefits available, the eligibility rules, the benefits election process, the procedure for making contributions, and special rules that apply to flexible spending accounts.
Most employee benefit plans are subject to the Employee Retirement Income Security Act (ERISA). This law requires employers to provide plan participants and beneficiaries a Summary Plan Description (SPD). As its name suggests, an SPD provides an overview of the plan. The document must be written in language employees can understand. It should explain the type of plan the employer is offering, what benefits are available, who is eligible, and other pertinent details. New employees must receive a copy of the SPD within 90 days of the date their coverage begins.
Highly Paid and Key Workers
Section 125 plans should be created so they don't discriminate in favor of highly-compensated workers or key employees. If a plan fails certain non-discrimination tests, any highly paid worker or key employee who participates in the plan will lose the tax deduction they otherwise would have received. When the individual files their income tax return, they must include the value of the taxable benefit (based on the greatest value the employee could have elected) in their gross income.