mall employers often face the difficult task of providing benefits to employees in a cost-effective manner. With health insurance premiums and other costs rising, many small businesses are forced to be creative or eliminate some benefits entirely. Since most owner/employees want to provide at least health insurance for themselves and their families—and usually for other employees—eliminating benefits generally is not an option. There is, however, an answer. Cafeteria plans under IRC section 125 and non-125 flexible benefit plans can help small employers provide necessary benefits in a way that helps mitigate rising costs.
TAXABLE VS. TAX-FREE
An employer can provide non-cash benefits to employees and usually deduct the cost. Some of them are tax-free, meaning the employee does not have to include the value in his or her taxable income. Among the benefits a company can provide tax-free are health insurance, medical expense reimbursement, dependent care reimbursement, disability insurance and long-term care insurance for the employee and his or her spouse and dependents. Employers are also permitted to make contributions to medical savings accounts (MSAs) and provide a limited amount of group term life insurance as well as provide certain fringe benefits (such as free employee parking). These benefits will be tax-free to the employee.
Under the principle of constructive receipt, if the employer gives the employee a choice between tax-free benefits and cash or another taxable benefit, the employee must pay income tax on the cash (or the value of the other taxable benefit). The employee is taxed even if he or she chooses an otherwise tax-free benefit rather than the cash. The tax law treats the employee as if he or she had chosen the cash and then used it to buy the benefit independent of the employer. In such instances, the employee would have to pay tax on the cash.
IRC section 125 outlines various requirements for “cafeteria plans,” which let employees choose cash or some of the tax-free benefits mentioned above and avoid income tax on the chosen tax-free benefits. A section 125 cafeteria plan overrides the constructive receipt doctrine—only the cash actually elected is included in the employee’s income. An employee may also elect to have his or her earnings reduced to pay for tax-free benefits over and above the amount the employer is willing to contribute. Indeed, many cafeteria plans are designed so an employee’s pay is reduced to cover the entire cost of tax-free benefits—the employer contributes nothing.
According to section 125’s requirements, no more than 25% of tax-free benefits under a cafeteria plan may go to key employees. (Key employees are generally certain owners—even small-percentage owners if they are highly paid—and certain high-paid officers.) This means that for every $3 in tax-free benefits non-key employees receive as a group under a cafeteria plan, key employees together may receive $1 in tax-free benefits.
As key employees typically have more income to spend on tax-free benefits than non-key employees, the 25% test often hampers key employees’ ability to fully enjoy a cafeteria plan’s tax savings. Typical situations in which the 25% concentration test poses a challenge include professional practices, such as doctors, lawyers or CPAs, and very small companies. These employers may find a cafeteria plan is often not worth the costs of design, documentation and administration—particularly if the ratio of non-key employees to key employees is not greater than 3 to 1.
Section 125 and other IRC sections also prohibit cafeteria plans from offering some tax-free benefits, such as fringe benefits, long-term care insurance coverage and contributions to an MSA.
MAXIMIZING ADVANTAGES FOR KEY EMPLOYEES
To bolster the tax-free benefits of non-key employees, and thus the benefits key employees can elect, a company may have a cafeteria plan but provide health insurance coverage to key employees “outside” the plan. In most instances, IRC section 162 allows the employer to deduct—as an ordinary and necessary business expense—the premiums it pays to provide health insurance coverage for employees. IRC section 106(a) excludes the value of this coverage from the employee’s taxable income (provided the employee is not given the choice of cash, as explained above). IRC section 105(b) excludes from the employee’s income whatever the insurance company pays for personal injury or illness expenses. There is no nondiscrimination requirement for benefits provided outside a section 125 cafeteria plan when employees do not have a cash alternative. The employer may freely chose which employees it will cover and is not required to cover all employees or all employees meeting any eligibility criteria.
An employer may simply decide to provide health insurance coverage only for key employees under sections 162 and 106(a)—outside the cafeteria plan. The value of this coverage does not count against key employees in the 25% concentration test. The cafeteria plan would make the same coverage available to all eligible employees—key and non-key alike. Of course, key employees would not elect this coverage because it would duplicate benefits already provided at the employer’s expense outside the cafeteria plan.
Non-key employees who want health insurance would have to elect it through the cafeteria plan. The employer would not pay to cover them outside that plan. When non-key employees elect health insurance through the cafeteria plan, they increase the amount key employees may elect in other tax-free benefits. For example, if non-key employees elect $9,000 a month in health insurance coverage, key employees could elect $3,000 a month of medical expense reimbursement.
Employer subsidies. Employers can also opt to offer a subsidy. If the actual premium for a certain type of health coverage costs the company $200 per month, for example, the employer can offer the coverage to employees at a cafeteria plan cost of just $80 per month in payroll deductions. In essence, the employer pays a $120 monthly subsidy for each employee who elects such coverage. The remaining $80 is deducted from the employee’s pay on a pretax basis. (Employees who don’t elect the coverage lose the $120 subsidy.) As long as the cost to the employee under the cafeteria plan is “substantial” in light of the actual cost, the entire actual amount is taken into account for purposes of the 25% concentration test. Informally, Harry Beker of the IRS National Office said that 35% to 40% would likely be considered substantial. If the ratio of non-key employees to key employees is greater than 3 to 1, a subsidy will let key employees elect more in other tax-free benefits.
If a company’s sole purpose in adding a subsidy is to allow key employees to elect more tax-free benefits under the cafeteria plan, the subsidy method is too costly. Suppose the subsidy for non-key employees costs the employer $1,200. The subsidy for key employees is $300 of that amount, but it will permit only key employees to elect $100 more in other tax-free benefits [($100 + $300) $100 + $300 + $1,200 = 25%]. The employer pays $1,500 so key employees can have $400 tax-free. This is an expensive way to get more tax-free benefits for key employees. It would be more cost-effective for the employer simply to pay key employees an additional $700, which would leave the employee roughly $400 aftertax. An employer can use the subsidies technique most effectively when it pays part, but not all, of the cost of employee benefits to attract and keep skilled workers.
OTHER FLEXIBLE BENEFITS
If an employer only allows employees to choose among tax-free benefits, the constructive receipt doctrine does not apply because the employees cannot choose cash instead of the tax-free benefits. If the employer permits employees only to chose among tax-free benefits, the requirements of section 125, including the 25% concentration test, do not apply, and the company may offer fringe benefits, long-term care insurance, MSA contributions and other tax-free choices. Such an arrangement would be a “non-125 flexible benefit plan.” (See the sidebar below for examples of how to use such plans wisely.)
This plan generally must not permit employees to defer compensation. For example, an employee may not have the choice of health insurance or retirement plan contributions. The reasons cited are constructive receipt and assignment of income. Retirement plan benefits are taxable either now or eventually—while they may be tax-deferred, they are not tax-free. Nevertheless, the plan may offer MSA contributions, discussed below, as tax-free benefit choices despite their potential to defer compensation beyond the end of the current tax year to the extent the employee does not withdraw the MSA contributions by yearend to cover medical expenses.
A company that includes MSA contributions as a choice in its non-125 flexible benefit plan may only offer other health coverage as other tax-free benefits in the plan. The statutory exception to including MSA contributions in taxable income—when they are just one option available to the employee—applies only if all the other options are health plans. Thus, an employee given a choice of MSA contributions may have the option to elect non-health tax-free benefits, such as dependent care or group term life insurance, or cash.
The employer bears the entire cost of all tax-free benefits in a non-125 flexible benefit plan. To contain costs, the plan document typically sets a cap on the total benefits any one employee may elect for a plan year. For example, assume the cap is $2,400 per employee. Since every employee is entitled to the same amount, and may elect to apply it toward any one benefit, giving employees the choice satisfies any discrimination requirements. With a medical expense reimbursement benefit, for example, it is nondiscriminatory if highly compensated employees may elect no more than non-highly compensated employees, regardless of how much either group actually elects.
If the non-125 flexible benefit plan offers health insurance coverage and the employer also provides such coverage to key employees outside the plan, key employees would apply their entire $2,400 to other benefits. Non-key employees who receive health insurance coverage through their spouse at no or little cost (and who previously permitted their employer to provide what amounted to duplicate coverage) are also likely to choose a benefit other than health insurance. If the employee chooses medical expense reimbursement, the employer will bear no additional cost above regular health insurance, even if non-key employees exhaust all of the medical expense reimbursement benefits they elected with qualifying expenses. However, if the employee uses less than 100%, the employer keeps the unused portion.
An employer that sets up a non-125 flexible benefit plan may also want a cafeteria plan. This would allow the company to get the greatest tax benefit for key employees from the total amount it contributes toward employee benefits. At the same time, the employer would be allowing employees to use pretax earnings to cover the cost of benefits beyond those they may elect in the non-125 flexible benefit plan. Key employees could, for every $3 non-key employees elect in tax-free benefits under the cafeteria plan, elect $1 of tax-free benefits for themselves. (The employer would also save its half of FICA taxes on amounts employees use for the extra benefits.)
Employers and employees alike disdain the use-it-or-lose-it rule that applies to medical flexible spending accounts (FSAs). If an employee does not use his or her medical FSA by the end of the plan year, the unused balance is an “experience gain” and lost to the employee. If the medical FSA is part of a cafeteria plan, the gains are applied first to offset net experience losses from prior years, then to reimburse the employer for its administrative costs and finally to benefit employees.
If the medical FSA is part of a non-125 flexible benefits plan, the employer keeps the gain. If an employer maintains both plans, the non-125 flexible benefit plan should have an ordering clause. For example, the clause might say that the medical FSA benefits in the non-125 flexible benefit plan will not be available to reimburse the employee’s qualifying medical expenses until he or she has exhausted the medical FSA in the qualifying cafeteria plan. In this way the employer can keep more than if the employee were permitted to apply for reimbursement under either plan and chose to use the non-125 flexible benefit plan first.
Proposed Treasury regulations address the rules regarding medical FSAs in cafeteria plans. One mentions some of the salient aspects of medical FSAs but not experience gains. Paragraph (a) of proposed Treasury regulations section 1.125-2, Q&A-7, says in part, “[t]hese rules apply with respect to a health plan without regard to whether the plan is provided through a cafeteria plan.” Thus, if a non-125 flexible benefit plan includes FSAs, these rules would apply as if they were in a cafeteria plan. If “these rules” refers only to those previously mentioned in paragraph (a), then not mentioning experience gains would make the ordering clause an advisable design option. If the reference includes all those addressed in Q&A-7, it would preempt the clause and all experience gains from both plans would be used as if they came from a section 125 cafeteria plan, including gains from the non-125 flexible benefit plan, and not simply remain with the employer.
The use-it-or-lose-it rule for medical FSAs removes any employee incentive to use the account judiciously. There is no check and balance on incurring unnecessary medical expenses. In a cafeteria plan, there is no alternative to a medical FSA for paying such expenses tax-free, but there is in a non-125 flexible benefit plan: the MSA. If an employee has only certain high-deductible major medical insurance coverage (which can be an alternative to regular major medical insurance under a non-125 flexible benefit plan), the employee can have an MSA if the employer is a “small employer.” At the employee’s election such an employer can make a deductible contribution of a percentage of the high annual deductible to the employee’s MSA. If the employee draws money to pay medical expenses, it is not taxable (even if the employee’s out-of-pocket medical expenses for the year do not exceed 7.5% of the employee’s adjusted gross income or if the employee takes the standard deduction instead of itemizing). If the employee does not use the money, and does not withdraw it until retirement, the benefits are taxed at withdrawal similar to an IRA under IRC section 408 or an employee retirement plan under IRC section 401(a).
DON’T OVERLOOK THE OBVIOUS
Cafeteria plans and non-125 flexible benefit plans provide many opportunities for small employers. Companies that overlook them miss out on substantial tax savings for themselves and their employees, particularly owner/ employees. While each employer’s particular situation will vary, CPAs will find that individual analysis and tailoring of a benefits package will provide most employers with significant income tax savings.