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Common Compliance Issues: Failure to Maintain a Section 125 Plan

on Wednesday, 15 May 2024 in Benefits Quarterly: Morgan L. Kreiser, Editor

As employee benefits attorneys, one of the most common compliance mistakes we encounter while advising clients is the employer’s failure to adopt and maintain a Section 125 plan.  Whether we are onboarding a new client or assisting a client in purchasing or selling a business, one of the first items we request for review is a copy of the client’s (or in the event of a client’s purchase of a new business, the target employer’s) Section 125 plan.  Too often, responses to this request are met with comments such as “I know we had one at one time, but I have no idea where it is” or simply “oh, we don’t have one of those.”  In this (first) edition of “Common Compliance Issues,” we discuss Section 125 plans and when and why it is imperative for your business to have one.

What is a Section 125 Plan?

Named for the section of the Internal Revenue Code (the “Code”) that created it, a Section 125 plan (also commonly known or referred to as a “cafeteria plan,” a “flexible benefit plan,” or a “premium conversion plan”) is, at its very core, the sole mechanism through which an employer may permit an employee to make contributions to qualified health and welfare benefits on a pre-tax basis.  Without a Section 125 plan, employees would only be able to pay their share of qualified benefits (such as group health plan premiums) with post-tax dollars.

How does a Section 125 Plan work?

The IRS prescribes to what is known as the “doctrine of constructive receipt.” Under this doctrine, compensation that an employee refuses generally is treated as taxable gross income for the first year the employee had a right to receive it.  Without Section 125, where an employer gives an employee a choice between a taxable benefit or a tax-free benefit, the employee’s ability to elect the taxable benefit would result in taxation to the employee, even if the employee elects to forgo the taxable benefit in favor of the tax-free benefit. To avoid this result, Section 125 of the Code provides that an employer may, through a plan that satisfies the requirements of Section 125, offer its employees the ability to choose between one or more taxable benefits (typically, cash) or the ability to forgo the taxable benefit in exchange for a pre-tax benefit without being taxed on the value of the taxable benefit.

What are the advantages of a Section 125 Plan to employees?

A Section 125 Plan allows employees to reduce their taxable income by forgoing cash compensation and instead electing to pay for certain eligible benefits on a pre-tax basis.  This results in both federal and state income and employment tax savings to the employee.

What are the advantages of a Section 125 Plan to an employer?

The primary advantage of a Section 125 Plan to the employer is that it provides a Code-compliant mechanism for employees to elect to receive tax-free benefits.  Without a compliant Section 125 Plan in place, the employer would be responsible for withholding and depositing applicable income and employment taxes on electing employees’ behalves.  However, a Section 125 Plan also provides tax savings to the employer in the form of the employer’s reduced share of employment taxes (such as FICA) on the amount of pre-tax benefits elected by employees.

What qualified benefits may be offered on a pre-tax basis under a Section 125 Plan?

Generally, Section 125 Plans may offer the following qualified benefits:

  • Medical benefits (including major medical, dental, vision, and prescription drug coverage).
  • Life insurance coverage (for example, group term).
  • Accident or health plans.
  • Paid time off.
  • Health savings accounts (HSAs).
  • Dependent care assistance.
  • Long-term or short-term disability policies.
  • Adoption assistance.

However, just because a Section 125 Plan may allow employees to elect certain qualified benefits on a tax-free does not mean that it is always in the best interest of the employee to do so.  For example, where short-term disability plan premiums are paid on a pre-tax basis under a Section 125 Plan, the benefits under the short-term disability plan will be taxable, whereas if the employee paid short-term disability premiums on an after-tax basis, the benefits would be tax-free.

What benefits may not be offered on a pre-tax basis under a Section 125 Plan?

A Section 125 Plan generally may not include benefits that result in the deferral of compensation. Also, the following non-qualified benefits may not be offered through a Section 125 Plan:

  • Long-term care insurance and long-term care services.
  • Scholarships under Code Section 117.
  • Employer-provided meals and lodging under Code Section 119.
  • Employer vanpooling.
  • Health reimbursement arrangements (HRAs) that:
    • provide reimbursements up to a maximum dollar amount; and
    • carry forward unused funds from previous plan periods.
  • Short-term, limited-duration insurance (STLDI).
  • Fringe benefits under Code Section 132.
  • Employer-sponsored educational assistance programs under Code Section 127.
  • Contributions to Archer medical savings accounts.
  • Deferrals to Code Section 403(b) plans.

What other requirements apply to a Section 125 Plan?

To receive favorable tax treatment, a Section 125 Plan must be committed to writing in a document that addresses the following topics:

  • The plan must offer participants a choice between cash and one or more qualified benefits. Plans may automatically enroll employees for benefits unless employees affirmatively elect to receive cash.
  • Only current and former employees (and their dependents) can participate in the plan, but:
    • the plan cannot primarily benefit former employees; and
    • spouses are limited to elections on behalf of a deceased employee-spouse.
  • The availability of benefits under the plan cannot discriminate in favor of highly compensated employees.
  • Actual benefits paid to certain key employees may not exceed 25% of the aggregate of all such benefits provided that year.
  • An election to take a qualified benefit instead of cash must:
    • be made before the beginning of the plan year; and
    • not change during the year except for a change in status.
    • Restrictions on medical expense and dependent care expense reimbursement accounts, if those accounts are offered.
  • A specific description of the benefits available under the plan.
  • The plan’s eligibility rules governing participation.
  • Benefit election procedures.
  • How plan contributions will be made (for example, through a salary reduction agreement or nonelective employer contributions).
  • The maximum amount of participant contributions under the plan.
  • The plan year.

Additionally, various other laws may apply to a Section 125 Plan depending on plan design choices and the benefits offered under the Plan, including ERISA, COBRA, HIPAA, GINA, and more.

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In short, employers that allow employees to elect qualified benefits on a pre-tax basis must have a written Section 125 Plan in place.  Section 125 Plans can take many forms, and employers should consult with qualified benefits counsel to design a plan that satisfies the legal requirements of Section 125, accommodates the various benefits an employer offers to its employees, and complements the employer’s objectives with respect to employee retention and relations.

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