The labor market is tighter today than it has been in decades, and many employers are going above and beyond the ordinary to attract and retain top talent. One idea for your organization is to sweeten the pot of fringe benefits. A cafeteria plan, for example, allows employers to offer more benefits to employees, generally at a reasonable cost. This type of plan also provides tax-favored perks to employees under Section 125 of the tax code. (This is why cafeteria plans are sometimes called Sec. 125 plans.) Plus, payments are tax-deductible by employers.
In the Mix
A cafeteria plan enables employees to pick and choose from a menu of fringe benefits. To qualify for favorable tax treatment, your plan must be in writing and maintained according to Sec. 125 and other applicable regulations. If these requirements are met, participants can receive the benefits they select on a pretax basis. Each participant can choose between a taxable benefit, such as cash, and various tax-exempt benefits, including:
- Accident and health benefits (but not Archer Medical Savings Accounts or long-term care insurance),
- Adoption assistance,
- Dependent care assistance,
- Group term life insurance coverage above $50,000, and
- Health Savings Accounts (HSAs), including distributions used to pay long-term care services.
Your written plan must describe all benefits and establish rules for eligibility and elections. You must allow all employees who worked at least 1,000 hours in the previous year to participate. However, you may choose to exclude employees who are under age 21 before the end of the tax year or have less than one year of service. Otherwise, eligible employees are free to select the fringe benefits they want, subject to tax law limits and requirements.
There’s another bonus to consider: Benefits may be extended to employees’ spouses and dependents. Former employees may also be covered. However, your plan can’t exist primarily to benefit former employees.
Cafeteria plans allow employees to save:
Income tax. Usually, amounts are deducted from employee paychecks on a pretax basis under a salary reduction agreement. Salary reduction contributions aren’t actually or constructively received by the participant. Therefore, contributions aren’t subject to federal income tax.
Payroll tax. Similar to federal income tax, most qualified benefits under a cafeteria plan aren’t subject to FICA, FUTA, Medicare tax or income tax withholding. However, group term life insurance above $50,000 of coverage is subject to Social Security and Medicare taxes — but not FUTA tax or income tax withholding. Adoption assistance benefits are subject to Social Security, Medicare and FUTA taxes, but not income tax withholding. If an employee elects to receive cash instead of a qualified benefit, the compensation is subject to all payroll taxes.
Different from FSAs
Be careful not to confuse cafeteria plans with flexible spending accounts (FSAs). An FSA is a form of a cafeteria plan, also funded by salary reduction, that reimburses employees for expenses incurred for certain qualified benefits. Specifically, an FSA may be offered for health care and dependent care expenses.
Unlike a cafeteria plan, contributions to a health care FSA in 2022 are limited to $2,850. In addition, a “use-it-or-lose-it” rule applies unless the employer provides a 2½ month grace period or a $550 carryover to the following year.
A statutory limit of $5,000 per year applies to dependent care assistance benefits from either an FSA or a cafeteria plan. The total dependent care benefits your organization pays to an employee or incurs on the employee’s behalf (including amounts from a cafeteria plan) are reported on Form W-2. Any amount over $5,000 should be included in wages.
Special Rules for Owners
Generally, owner-employees may participate in a cafeteria plan. But special rules apply to certain owners. For example:
Sole proprietors. These owners can’t directly participate in a cafeteria plan, but they may legitimately employ their spouse and offer the spouse plan benefits. In these cases, the employer must ensure the plan is offered on a nondiscriminatory basis.
Partners. Partnerships operate much like sole proprietorships. Although partners can’t directly participate, they also can employ spouses and extend benefits to them.
More-than-2% shareholders of S corporations. These shareholders can’t participate in the plan, nor may their spouses or dependents, even if those family members are employed by the company.
Building a Plan
This is only a brief overview of cafeteria plans. If you’re initiating a new plan, be sure to work with your tax advisor and, possibly, a benefits specialist to ensure you fully follow all applicable rules.