Financial Education Blog

 Brandi C. Williams, MAcc

Section 125 Cafeteria Plans for Small Businesses

A Cafeteria Plan includes one of the many benefits plans that employees can choose from and are maintained by the employer. Employees, based on their specific needs, can choose from a variety of benefits plans, and contribute accordingly from their gross salary. Cafeteria plans are regulated under Section 125 of the Internal Revenue Code. 

The following are the main type of Cafeteria Plans:

1. Health Saving Account: An employee meeting the requirements can use pre-tax income to set up a Health Saving Account (HSA) for paying the deductibles related to health care expenses. This account can also be used for bearing out-of-pocket expenses related to medical care. Within its maximum limits (2022: $3,650 for an individual and $7,300 for a family), the employer may also contribute into the program.
2. Group Life: An employer may set up a group life insurance coverage for the employees where employees contribute pre-tax income to the program, along with the employer making equal contributions.
3. Accident & Health Benefits: Similarly, a separate account may be set up allowing for accidental and other health coverages for the employees.
4. Adoption Assistance: Employers may sponsor an Adoption Assistance Program (AAP) to employees which covers all major expenses related to adoption, such as adoption agency fees, court fees and travel expenses. However, unused amount in an AAP cafeteria plan can be carried forward to the next year.
5. Dependent Care Assistance: Employees can set up a Dependent Care Assistance Plan (DCAP) to pay for the care of their dependents. A qualified dependent is 12 years old or younger and must be living with them. A 13-year-old or older mentally or physically challenged dependent may also be qualified for this purpose. The 2022 maximum pre-tax contribution limit set by the IRS for this type of plan is $5,000 for each household or married filing separately, $2,500 per parent. 

For an employee to be eligible to subscribe to a cafeteria plan, the following requirements must be met:

• · Must be 21 years of age or older before the end of the plan year.
• · Have at least one year or more service with the employer.
• · Have worked at least 1,000 hours in the preceding year.

Employers must also contribute to the plan by fulfilling one of the two requirements below:

• · Contribute a uniform percentage of each plan-eligible employee’s compensation, which should not be less than 2%.
• · Contribute at least 6% of the employee’s compensation for the plan year, twice the amount contributed by the employee.

A cafeteria plan may provide the following tax benefits to employers:

• · A Better Benefits Package: Since an employer, by subscribing to a cafeteria plan, agrees to support employees in addition to routine pay packages, it improves the overall compensation package offered by the job. It helps reduce the turnover and improves employees’ motivation and dedication towards the job.
• · Reduced Payroll Taxes: As cafeteria plans reduce the taxable portion of the employees’ compensation, the amount of certain employer-paid taxes, such as employer’s portion of Medicare, social security and Federal unemployment taxes is reduced.
• · Retain Unused Balances: If DCAP and FSA plans are set up by using the “use it or lose it” clause, the employer gets to retain unused balances if an employee leaves the company or at the end of the plan year.

Similarly, cafeteria plans provide several tax benefits to the employees, such as:

• Reduced Tax Liability: As employees make pre-tax contributions to these plans, their taxable income is reduced; hence, reducing the tax liability.
•  Choice of the Plan: A number of cafeteria plans exist, such as accident coverage, adoption assistance and health saving account. So, an employee may choose one which suits his or her future needs the best.
• Taxable VS Non-taxable Benefits:Plans like insurance and retirement contributions are non-taxable, while certain other plans are taxable. Hence, employees get the opportunity to choose according to their tax preferences.

The Internal Revenue Services (IRS) requires a series of eligibility and benefits tests every year to ensure that cafeteria plans remain non-discriminatory, i.e. not favoring those in charge of a company’s management or those with higher compensation packages. These tests are either performed by the employer or a third-party, and typically look at dependent care flexible spending accounts, healthcare flexible spending accounts and pre-tax premiums under these plans. 

This testing involves several calculations related to compensations and taxes to ensure that fair advantage is being provided to all employees of the business. 

All employers with active cafeteria plans, including small businesses, government entities and churches are required to undergo this testing. The results are due on or before the last day of the plan year.

 Hiring a professional tax consultant to help you through all stages of filing and paying taxes is a reasonable alternative. A tax professional may also help you in minimizing your tax liability by using his or her experience and knowledge of various options available in the tax code. 

 IRS CIRCULAR 230 DISCLOSURE: To comply with requirements imposed by the Department of the Treasury, we inform you that any U.S. tax advice contained in this communication (including any attachments) is not intended or written by the practitioner to be used, and that it cannot be used by any taxpayer, for the purpose of (i) avoiding penalties that may be imposed on the taxpayer, and (ii) supporting the promotion or marketing of any transactions or matters addressed herein.