Tax Benefits of Cafeteria Plans

As healthcare and childcare costs continue to climb, flexible spending accountsor cafeteria planshave been gaining in popularity.

Definition

Cafeteria plans provide cost-conscious companies with a way to extend additional pre-tax benefits to employees, who can customize a plan to meet their needs; the cost savings benefit employees and employers alike. Such plans also bolster employees morale, as well as their wallets; see the Exhibit below.

A Sec. 125 cafeteria plan is a written document authorized by the IRS. It is a menu of benefits. Each employee selects the benefits he or she wants (e.g., medical care, childcare), then pays for those benefits by redirecting a portion of his or her salary. The amounts are redirected before they are subject to Federal income tax or Social Security taxes; thus, both the employer and employee save on payroll taxes. For example, if employees redirect $300,000 in salaries, the employer would save $22,950 in FICA, at 7.65%.

Plan Mechanics

Redirected amounts go into a separate spending account. As an employee incurs a qualifying expense, he or she submits a claim to a plan administrator, who processes the claim and reimburses the employee from plan funds.

Adopting a cafeteria plan does not require a change in a group medical plan. The premium payments that employees make to cover their dependents are still handled through the payroll department; they are just converted to pre-tax deductions.

The only requirements are to adopt a plan, execute a plan document and have all eligible employees make their benefit elections. The plan administrator must give all employees summary plan descriptions detailing eligibility requirements, benefits and election alternatives.

Permissible Benefits

Typically, eligible expenses are items not covered by insurance, such as deductibles, hearing and vision care, routine exams and vaccinations. Other examples are:

• Dependent care (subject to limits);

• Dental care;

• Group-term life insurance;

• Accident and health plan coverage;

• Medical reimbursements;

• Disability insurance; and

• Health savings accounts.

Caveats

Cafeteria plans come with some restrictions. Menu selections, once made, are irrevocable for that plan year. Certain exceptions, such as a change in family status through the birth of a child, are permissible. Also, funds left in an employee account at the end of the year are forfeited and become an asset of the employer (i.e., use it or lose it). For this reason, participants need to carefully estimate reimbursable expenses before each plan year begins. When an employee is notified near year-end that funds are left in the account, he or she should go for that overdue checkup or get those new eyeglasses.

On the employers side, cafeteria plans must be nondiscriminatory in nature. While such plans can provide significant cost advantages, they can also add to a companys administrative and recordkeeping burdens. However, Form 5500, Annual Return/Report of Employee Benefit Plan, Schedule F, Fringe Benefit Plan Annual Information Return, which previously had to be filed annually to ensure that a plan did not favor highly compensated employees as to participation, contributions and benefits, no longer needs to be filed; see Notice 2002-24.

Another important consideration is to know which professionals cannot participate in cafeteria plans. Partners, limited liability company members, sole proprietors and those who own 2% or more of an S corporation cannot participate. This restriction does not apply to professionals in C corporations.

From John B. Wollenberg, CPA, Friedman LLP, Livingston, NJ