An Internal Revenue Code (IRC) Section 125 cafeteria plan is a method of allowing employees to pay for qualified benefits on a pretax basis. In its simplest form, it is a premium only plan (POP), which allows employees to pay for health insurance premiums before tax. In its most complicated form, an employer may offer employees flex credits to select among various benefits or a cash-out option.
Qualified benefits that may be offered through a cafeteria plan include:
- Accident and health benefits
- Adoption assistance plans
- Dependent care assistance plans
- Group-term life insurance coverage
- Health savings accounts (HSAs)
Benefits that are not permitted under a cafeteria plan include: long-term care insurance, Archer Medical Savings Accounts (MSAs), educational assistance, and moving expenses.
Who Can Sponsor and Who Can Participate
Any employer with employees subject to U.S. income taxes can sponsor a Section 125 cafeteria plan, regardless of size. For this purpose, an employer can include private employers, corporations (Subchapter S or Subchapter C), partnerships, nonprofit organizations, limited liability companies (LLCs), limited liability partnerships (LLPs), sole proprietorships and government employers. Additionally, businesses that are under common control or part of a controlled group or affiliated service group can choose to provide a single plan for all of their employees, or several plans which vary among the business entities, location or other bona-fide employment classifications.
Assuming the employer is sponsoring a Section 125 cafeteria plan, who may actually participate in the offering? A Section 125 cafeteria plan may extend participation only to current and former employees of the employer. The definition of "employees" generally includes common-law employees and former common-law employees. Leased employees and full-time life insurance salespersons who are statutory employees are eligible to participate as well as nonresident aliens receiving U.S.-source income (although restrictions may apply).
Individuals who are not eligible to participate in the Section 125 cafeteria plan include spouses and dependents. However, the employee may elect coverage on their behalf, but the spouse or dependent does not have a right to make an independent election under the plan. Also, self-employed individuals are not considered employees and thus, cannot participate in the Section 125 cafeteria plan. A self-employed individual includes a sole proprietor, a partner in a partnership or a director serving on a corporation's board of directors who does not provide services to the corporation as an employee. In some cases, the spouse and other family members of a self-employed individual are restricted in their participation as well. Additionally, partners in a partnership and more-than-2-percent shareholders cannot participate in a Section 125 cafeteria plan and are expressly excluded from participation under the Section 125 cafeteria plan regulations.
Written Plan Document Requirement
The IRC requires that a Section 125 cafeteria plan be in writing prior to the plan's effective date. If a plan is not in writing or does not operate according to its written document, the proposed rules issued in 2007 indicate that the plan could lose its tax-favored status, resulting in tax liability for the employees and employer. Learn more about the written plan document requirement here.
When Can Employees Change Their Elections?
Participants in a Section 125 cafeteria plan must be given the opportunity at least annually to make or change elections. This is typically during an open enrollment period. However, a Section 125 cafeteria plan is not required to allow midyear changes. Learn more about qualifying events.
At minimum, a Section 125 cafeteria plan must permit certain individuals who qualify for HIPAA Special Enrollment Rights to enroll in coverage. However, the Section 125 cafeteria plan may be designed that the individual must pay for the coverage on a post-tax basis outside of the Section 125 cafeteria plan until the next enrollment period. For more information on Special Enrollment Rights, please see the HIPAA section of this website.
Additionally, upon the decision of the plan sponsor and provision in the plan document, a Section 125 cafeteria plan may permit midyear changes based on the following events:
- Change in status (including marital status, number of dependents, employment status, dependent ceases to satisfy eligibility requirements, change in residence or adoption)
- Change in cost with an automatic increase or decrease to employee contributions
- Significant cost changes
- Significant curtailment in coverage (including loss of coverage, increase in copayments or increase in coinsurance)
- Addition or significant improvement of benefit options
- Change in coverage under other employer plan
- Loss of group health coverage through government or educational institution
- Entitlement to Medicare or Medicaid
- Leave of absence under the Family and Medical Leave Act or the Uniformed Services Employment and Reemployment Rights Act
If the plan receives a judgment, decree or order requiring coverage for an employee's dependent child, such as a Qualified Medical Child Support Order (QMCSO), the plan should allow the addition of coverage. However, as with the HIPAA Special Enrollment Rights, the plan may decide that the individual must pay for the coverage on a post-tax basis outside of the Section 125 cafeteria plan until the next enrollment period.
The change in election must be consistent with the event, and the plan may allow "tag-along" changes for existing spouses and dependent children.
A Section 125 cafeteria plan is subject to nondiscrimination rules under IRC Section 125. Generally, those rules prohibit a Section 125 cafeteria plan from discriminating in favor of highly compensated individuals (HCIs) as to plan eligibility and benefits. Learn more about the nondiscrimination requirements..
Employer Action Required
Employers who permit employees to pay premiums on a pretax basis must have a POP or Section 125 plan document in place. They also have a responsibility to maintain the plan's qualified status, which usually means periodically amending the plan, planning ahead for the enrollment process, monitoring election change requests and confirming that requests are in compliance with the Section 125 qualifying events, performing annual nondiscrimination testing, and keeping records for the plan.
Penalties for Noncompliance
The penalty for failing to comply with the Section 125 requirements could be severe — including the imposition of income taxes against participants, employment taxes against the employer and employees, and penalties for failing to withhold and report taxes properly. The 2007 proposed cafeteria plan regulations make it clear that an operational or documentation error can cause the entire Section 125 cafeteria plan to be disqualified. The regulations include examples of operational failures ranging from failure to comply with the use-or-lose rule to payment of an ineligible expense from an FSA. Under the regulations, a plan that fails to operate in accordance with its terms or otherwise fails to comply with the IRC or regulations "is not a cafeteria plan and employees' elections between taxable and nontaxable benefits result in gross income to employees." Thus, a mistake under a Section 125 cafeteria plan covering thousands of employees could result in taxable income to all participants. Moreover, errors in violation of ERISA, COBRA and HIPAA can expose a sponsor to damages from private lawsuits as well as penalties.
Frequently Asked Questions
Q1: Can a 2 percent S-Corp shareholder participate in a cafeteria plan?
A: No, a 2 percent S-Corp shareholder is not considered an employee and would therefore not be permitted to make pre-tax contributions under a cafeteria plan. The same would apply to a sole proprietor and partners in a partnership.
Q2: Is an HSA subject to the rules regarding midyear changes?
A: No, the rules regarding midyear changes do not apply to HSAs. An HSA must permit participants to change elections at least monthly — even if the HSA is provided through the cafeteria plan. However, the change must be prospective.
Q3: May owners of an LLC (usually called "LLC members") participate in the LLC's medical plan or cafeteria plan?
A. An LLC's health plans may create special issues with respect to LLC member participation. This is because LLCs may be treated as either a partnership or a corporation (depending on how the LLC has elected to be treated), and for tax purposes the IRC treats partnerships and corporations differently. No IRS guidance specifically addresses the status of LLC members for purposes of health plan participation, including participation in a medical or cafeteria plan. But the general rules of Section 125 would likely apply as described below.
LLC Structured as a Partnership
Pretax premium payroll deductions are subject to IRC Section 125. Under Section 125, as a general rule only employees are eligible to participate in the cafeteria plan. Partners in a partnership are considered self-employed individuals, not employees. Thus, for LLCs that are taxed as partnerships, members of the LLC generally cannot participate in a cafeteria plan. This means that the LLC members would not be eligible to benefit from the tax advantages of paying premiums on a pre-tax basis. But those LLC members may still be eligible to participate (on an after-tax basis) in the medical policy/plan as an eligible person, depending on the definition of eligibility under the plan.
If, however, the plan is offered on a post-tax basis outside of a cafeteria plan, or on a non-contributory basis (where the employer pays all of the premiums), then the owner may participate in the group health plan. In addition, if they are self-employed as LLC members, the members may be able to take a deduction on their federal income tax returns; this would really be a taxation issue best addressed by an accountant or tax counsel.
LLC Structured as a C Corporation Where LLC Members Are Considered Employees Because They Are Receiving W-2 Reportable Wages
If the LLC has elected to be taxed as a C Corporation, then the LLC member may be considered an employee eligible to participate in the cafeteria plan. That said, the salary reduction under the cafeteria plan may only be from the individual's compensation as an employee.
- Code § 125
- Prop. Treas. Reg. § 1.125-1, 1.125-2, 1.125-5, 1.125-6 and 1.125-7, published on August 6, 2007. May be relied upon for guidance, although still in proposed format.
- Treas. Reg. § 1.125-3, published on October 17, 2001
- Treas. Reg. § 1.125-4, published on March 23, 2000
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