As noted in a recent SHRM study, employers continue to offer more employee benefits to attract and retain talent. In turn, successfully implementing section 125 strategies is smart business.

In this article, I’ll explain why it’s smart business – and the six key components you need to keep in mind to ensure you’re staying compliant.

What is Section 125?

Cafeteria plans, (often called flexible benefit programs or flex plans) are employer-sponsored benefit programs offering tax advantages under §125 of the Internal Revenue Code. A section 125 plan is the only means that an employer can offer employees a choice between taxable income and nontaxable benefits without the choice causing the benefits to become taxable.

A cafeteria plan allows an employee to pay for certain benefits from gross pay, before federal income taxes, Social Security taxes, and, in most cases, state income taxes are deducted.

A premium only plan (POP), or premium conversion plan:  The employer is simply offering a way to obtain favorable tax treatment on benefits already offered. POPs work in the following ways:

  • Employees’ premium contributions are automatically deducted from their salaries before taxes are taken out.
  • Taxable income is reduced by the amount withheld, so employees pay less in taxes and have more take-home pay.
  • With employee taxable income reduced, employers and employees pay less in FICA payroll taxes.
  • Premiums sheltered through premium conversion must be for coverage under certain qualified benefits, such as group health coverage.
  • Most companies currently have this set up through their payroll provider. A POP plan is the simplest type of §125 plan and requires little maintenance once it has been established, requiring updates when there are changes to things such as plan eligibility or benefits offered.

Written plan requirement.

When an employer adopts a section 125 plan, it must be in writing. To note, a summary plan description (SPD), certificate of coverage, summary of benefits and coverage and a master contract is not a plan document.

The plan document is a written document that describes:

  • The participant’s rights.
  • The participant’s benefits.
  • The participant’s obligations within the plan.
  • The terms and conditions for administering the plan.

Every employer who maintains a Health & Welfare Benefit Plan that is subject to ERISA must have a separate written plan document for each of the IRS and ERISA requirements. Your ERISA documents do not satisfy the IRS’ written document requirement for cafeteria plans.

The tax code does not impose any specific disclosure requirements for participants, however, there is an aspect of informing those who are enrolled under ERISA covered benefits – the participants of your plan.

The Summary Plan Description (SPD) is an important written document that a plan administrator must provide automatically and free of charge to participants of an ERISA covered health benefit plan. 

The SPD is designed to inform participants and their beneficiaries of their benefits and rights under the plan. The SPD explains what coverage the plan offers, how the plan operates, and the rights and responsibilities of participants and beneficiaries. It provides information on when an employee can begin to participate in the plan, how service and benefits are calculated, when benefits becomes vested, when and in what form benefits are paid, and how to file a claim for benefits.

Almost every employee benefits plan is required by ERISA to have an SPD on file and it must be distributed to plan participants in a manner that confirms receipt. It is important to note that even though a Third Party Administrator (TPA) or insurer may produce and distribute the SPD, the distribution of the SPD is the sole responsibility of the plan administrator and not the insurer or TPA.

The Department of Labor (DOL) requires plan administrators to provide participants with an SPD within 90 days of coverage or within 120 days of the plans effective date.

Offer of choice.

Not all types of benefits can be offered under a cafeteria plan. The following is a list of benefits that can be included as part of an overall cafeteria plan.

Plans that can be offered via section 125:

  • Medical
  • Dental
  • Vision
  • Rx
  • Life
  • STD
  • LTD
  • AD&D
  • Wellness plan
  • Group voluntary life
  • FSA
  • HSA
  • DCAP
  • Adoption assistance
  • Voluntary life
  • Voluntary dependent life
  • Voluntary AD&D
  • Voluntary LTD
  • Voluntary STD
  • Voluntary long-term care
  • Voluntary critical illness and cancer

Plans that can’t be offered via section 125:

  • Spousal or dependent life
  • HRA
  • Archer MSA
  • Prepaid legal
  • Educational Assistance Programs
  • Transit-commuter benefits

Remember, a cafeteria plan is a true choice and that enrollment materials and the SPD are going to outline what those choices are and the eligibility provisions that are going to fall right along with that.

Employee benefit.

An important factor to remember is that these plans are truly an employee benefit.

So, who can participate in a cafeteria plan? Check out this chart below.

 

C-Corp

S-Corp – More-than-2% Shareholder

Partnership

Sole Proprietor

LLC

Owner/Partner/Shareholder (O/P/S)

Yes

No

No

No

Sometimes**

Employee-Spouse of O/P/S

 

Yes

 

No

Sometimes,

Yes*

Sometimes,

Yes*

Sometimes**

Employee-Dependent of O/P/S

 

Yes

 

No

Sometimes,

Yes*

Sometimes,

Yes*

Sometimes**

* The employee must be a ‘bona fide employee’ and must not be deemed to be self-employed (ex. the employee-spouse must not have invested his or her own assets in the business and must not be an owner under state marital or community property laws).

**LLC may elect to be taxed as any of several entities (ex. partnership or C-corp) an LLC members ability to participate in a cafeteria plan depends on the LLC’s tax election status and is outside the discussion of this article

Prospective elections.

While this component may seem like a no-brainer, it’s still an important one to mention. Generally, you have an open enrollment period that gives employees enough time to make conscientious decisions about their upcoming elections. In the case of cafeteria plans, here are some things to note:

  • Plans should communicate election periods.
  • Initial elections must be prospective.
  • Mid-year election changes must only be prospective except in the case of a birth or adoption of a child.
  • Qualifying events – generally 30 days’ notice.

Irrevocable elections.

Under cafeteria plans, another key component centers around irrevocable elections.

Here’s the rule: Once an election is made, a participant may not change the election during the period of coverage. Typically, a plan year is 12 months.

The IRS recognizes certain events as permissible mid-year election changes – meaning allowing an exception to the general irrevocability rule. These events fall into these groups:

  • Changes in status: This event is most frequent and encompasses a number of different participant life events including:
    • Change in legal marital status,
    • Change in number of dependents,
    • Change in employment status,
    • Dependent satisfies or ceases to satisfy dependent eligibility requirements,
    • Residence change.
    • For adoption assistance provided through a cafeteria plan, the commencement or termination of an adoption proceeding. 
  • Cost or coverage changes: These would take effect at the beginning of a cafeteria plan year and are simply communicated as part of open enrollment. However, in some cases, these changes occur at other times (like mid-year). Enabling participants’ pre-tax salary reductions to go with the flow of their component plan cost and coverage changes is what this group of events is designed to do.
  • Other laws or court orders: Under this category would include events that coordinate cafeteria plan election changes with requirements under other, non-cafeteria plan laws (e.g., 401(k) rules, HSA rules, HIPAA, COBRA, and health care reform). Of course, this adds a layer of complexity.

Nondiscrimination testing (NDT).

Although it’s sixth on the list, this component is extremely important. Here are a few things to know about NDT.

What is NDT?

The IRS created a series of tests designed to make sure that certain highly compensated participants don’t use or select more nontaxable (pre-tax) benefits than non-highly compensated employees.

Is NDT required?

Yes. In order to document a plan is in compliance, an annual test must be performed, and the results documented for each plan. Because corrections can’t be made after the end of the plan year, the impact and cost of learning a plan failed nondiscrimination testing in previous plan years can be significant.

What happens if my plan fails the test?

Nondiscrimination tests can’t be passed by making corrections after the end of the plan year.

The total amounts withheld from gross income for any health and welfare benefits that fail are included in gross income for highly compensated participants.

The employer must treat the amount of highly compensated employees’ salary reductions as taxable income for W-2 reporting and for income tax, FICA, and FUTA withholding.

When should plans be tested?

The plan tests must be passed as of the last day of the plan year.

What’s next for employers?

Comply, communicate, and distribute.

Here’s a handy checklist of questions to ask yourself when it comes to your benefits offering to make sure you’re properly complying, communicating, and distributing documents to employees.

  • Have you amended your documents and verified your administrative practices are consistent with the document?
  • Have you amended your POP to allow for the marketplace and stability period plan changes?
  • If you renewed your medial plan early, have you amended your plan documents?
  • Have you amended your POP document to include HSA contributions made through pre-tax payroll deductions, if applicable?
  • Have you completed NDT for your POP plan?

So, after learning these key components on cafeteria plans – are you in compliance?

PrimePay can help.

At PrimePay, we are committed to making your business run more efficiently. When you feel as though there are too many rules and regulations to keep track of, that's where PrimePay comes in. Click here to learn more about how PrimePay can help ensure your compliance. 

Disclaimer: Please note that this is not all inclusive. Our guidance is designed only to give general information on the issues actually covered. It is not intended to be a comprehensive summary of all laws which may be applicable to your situation, treat exhaustively the subjects covered, provide legal advice, or render a legal opinion. Consult your own legal advisor regarding specific application of the information to your own plan.