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 employees’ 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 also has rules in place to ensure that the plan’s benefit is not subjected to abuse. 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. That is why nondiscrimination rules are set. And the IRS Section 125 has its own set of parameters for nondiscrimination.

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.

The second rule of nondiscrimination is that the Section 125 plan should not show any partiality to “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.

The IRS Publication 15 states that should the Section 125 Plan favor HCEs or key 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. This also means that the rule would still apply regardless of whether the favored employee will avail of the benefit or not.

A cafeteria plan is deemed to be discriminatory if these employees enjoy more than 25% of the total non taxable benefits of all plan participants. Any Section 125 plan drawn through a collective bargaining agreement however, is assumed to be in accordance with the nondiscrimination rules.

So, if you’re offering a cafeteria plan, you must 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.

The rules of the IRS code also mandates employers to have their Section 125 plans undergo testing for compliance with nondiscrimination rules at the end of each 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 Section 125 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.

Visit us at http://taxfreepremiums.com to know you can stay in compliance with your cafeteria plan. You can also find a tax savings calculator that can help you determine just how much you’ll be able to save with a Section 125 POP Plan.