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Section 125 Cafeteria Plans – What’s Nondiscrimination?

Section 125 Cafeteria Plans – What’s Nondiscrimination?

A Section 125 Cafeteria Plan allows an employer to provide a range of health and dependent care benefits to employees on a pre-tax basis.  That is, the employee’s 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.  And that’s where nondiscrimination rules come in.  Section 125 has nondiscrimination rules all its own.

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.  The IRS says that this is 1)an officer with annual compensation of more than $160,000; 2) an employee who owns 5% of the business or 3) and employee who owns 1% of the business and whose annual pay is more than $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.  That means more wages for the employer to pay tax on.  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 should 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.

IRS regulations also require employers to test their plans for compliance with the nondiscrimination rules by the end of every 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 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 need help or just don’t have the time to do this, consider hiring a professional who can guide you through the minefield.

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