Cafeteria plans, which are governed by Internal Revenue Code (“IRC”) Section 125, are welfare benefit plans that enable participants to pay for certain benefits on a tax free basis. Cafeteria plans are the exclusive means by which an employer can offer employees the choice between taxable and nontaxable benefits without the election itself resulting in income inclusion by the participants. To receive the IRC Section 125 tax advantages, a cafeteria plan must meet certain legal requirements. Below is a list of several of these legal requirements and an explanation of each of them.
(1) Cafeteria plans must have a formal Plan Document.
One of the most common errors for employers who permit employees to pay for benefits on a pre-tax basis is the failure to have a written plan document. A written plan document is required by IRC Section 125 and must be adopted by the employer prior to the first day of the plan year to which the plan applies. The plan document must include the following:
- A specific description of each benefit offered under the plan;
- Eligibility rules for participation in the plan and a requirement that participants must be employees;
- Procedures for employee elections under the plan, including how and when an election may be made;
- An explanation of how employer contributions may be made under the plan; and
- The identification of the plan year.
The plan document may incorporate by referencing other documents that govern individual benefits. For instance, if an employer offers dependent care assistance plan (“DCAP”) benefits, the cafeteria plan may include a reference to the DCAP that is stated separately. The same rule applies for group health plans, adoption assistance plans, and all other benefits offered under a cafeteria plan.
(2) Cafeteria plans must offer certain benefits.
Cafeteria plans must offer at least one permitted taxable benefit and at least one qualified benefit. Taxable benefits include cash and other taxable benefits treated as cash, such as property and benefits purchased with employee after-tax contributions. Qualified benefits include, but are not limited to, group health coverage, dental/vision insurance, a health flexible spending arrangement, DCAP, life insurance, and disability benefits.
(3) Cafeteria plans must only be offered to eligible employees.
An employer’s common law employees are eligible to participate in a cafeteria plan. The cafeteria plan may also cover an employee’s spouse, dependent child who is under age 27, or the employee’s tax dependent. A cafeteria plan is not permitted to cover an independent contractor or self-employed individual such as a sole proprietor or a partner in a partnership. Shareholders of a C-Corporation may participate in a cafeteria plan, but shareholders in an S-Corporation that hold more than 2% of the company are not permitted to participate. Allowing shareholders in a C-Corporation to participate is permitted, but may cause issues with discrimination testing.
(4) Employee elections must be irrevocable.
Generally, participants will elect cafeteria plan benefits during the open enrollment period that predates the first day of the plan year. Once the plan year begins, the participant’s election is irrevocable unless certain changes in status or qualifying events occur. Changes in status include marriage, divorce, the birth of a child, a change in coverage under a qualified medical child support order, and enrollment in Medicare or Medicaid, among other certain changes. The Coronavirus Aid, Relief, and Economic Security Act (the “CARES Act”), passed in 2020, permits certain election changes for any reason. However, the CARES Act change is temporary, and cafeteria plans must be amended by the Plan Sponsor to permit this change. An amendment pertaining to the 2020 plan year must be adopted on or before December 31, 2021.
(5) Nondiscrimination testing must be satisfied.
Cafeteria plans must pass nondiscrimination testing. This testing generally ensures that highly compensated individuals do not receive more favorable benefits than non-highly compensated individuals. Highly compensated individuals include officers, 5% shareholders, highly compensated employees, and spouses or dependents of any of the preceding individuals. Nondiscrimination testing must be completed each year and the cafeteria plan must be operated in such a way that is not discriminatory. Additional nondiscrimination testing may be required depending on the benefits offered under the cafeteria plan.
Be careful! If you have a cafeteria plan that does not comply with all of these legal requirements, the benefits that your employees elect or could have elected will be treated as taxable income to them and/or highly compensated individuals may be subject to additional tax ramifications.