One of the more little discussed elements of the ObamaCare law is the creation of a streamlined system for small employers to offer pre-tax benefit plans to their employees.
A popular method of providing employee benefits, a cafeteria plan is a written plan maintained by an employer for its employees under which participants receive certain benefits they choose on a pretax basis. Effective January 1, 2011, the Patient Protection and Affordable Care Act (ACA) provides eligible small employers with the option of a simple cafeteria plan. The main advantage of the simple cafeteria plan over the traditional option is that it removes the obstacle of nondiscrimination requirements favoring highly compensated and key employees which disqualify many small businesses.
Cafeteria plans defined
Participants in cafeteria plans--governed by Internal Revenue Code Section 125--choose from a “menu” of benefits, hence the “cafeteria” label. Participants in a cafeteria plan must be allowed to choose among at least one taxable benefit (for example, cash) and one qualified benefit. A qualified benefit is one that is excluded from an employee’s gross income, including:
- accident and health benefits (excluding Archer medical savings accounts (MSAs) and long-term care insurance)
- dependent care assistance
- group-term life insurance coverage
- health savings accounts (HSAs)
Generally, a cafeteria plan can’t include benefits that defer pay.
The written plan must specifically describe all benefits and establish rules for eligibility and elections.
Cafeteria plans are funded through employee contributions made on a pretax basis, sometimes in combination with employer contributions.
What is so advantageous about offering employee benefits through a cafeteria plan? A cafeteria plan is the only means by which an employer can offer employees a choice between taxable and nontaxable benefits without the choice causing the benefits to become taxable.
Employees’ pretax contributions mean they enjoy tax savings while paying for valuable benefits, and employers save on the amount of federal payroll taxes owed when employees’ taxable pay is reduced. It’s a win-win for both employer and employee.
Traditional cafeteria plans are subject to nondiscrimination rules meaning that a plan cannot favor highly compensated employees as to eligibility to participate, contributions, or benefits. If the nondiscrimination rules are violated, the value of the taxable benefits that the employee could have selected are included in the employee’s wages. Obviously, not a good result!
A highly compensated employee is any of the following:
- an officer
- a shareholder who owns more than 5 percent of the voting power or value of all classes of the employer’s stock
- an employee who is highly compensated based on the facts and circumstances
- a spouse or dependent of any of the above
Similarly, if a cafeteria plan favors key employees, which occurs when more than 25 percent of the total of nontaxable benefits provided for employees go to key employees, the value of the taxable benefits that employees could have selected are included in the employees’ wages. A key employee is:
- an officer having annual pay of more than $165,000, or
- an employee who is either:
- a 5 percent owner of the business
- a 1 percent owner of the business whose annual pay is more than $150,000.
Small employers can easily run afoul of cafeteria plan nondiscrimination rules. For example, the percentage of a plan’s pretax benefits may favor key owner/employees simply because of the fewer number of employees overall.
To make it possible for more small employers to take advantage of cafeteria plans, Congress amended the Internal Revenue Code to allow eligible employers' cafeteria plans to qualify as simple cafeteria plans. Simple cafeteria plans are treated as meeting certain nondiscrimination requirements and benefits for cafeteria plans.
Is a simple cafeteria plan an option for you?
The first step in determining whether a simple cafeteria plan is an option for you is to determine whether you are an eligible employer. Your plan must then meet eligibility and participation requirements as well as contribution requirements.
Eligible small employers. You are an eligible employer if you employ an average of 100 or fewer employees during either of the preceding two years. What if your business wasn’t in existence throughout the prior year? In that case you are eligible if you reasonably expect to employ an average of 100 or fewer employees in the current year.
You may be wondering what happens to your eligibility if you grow your business and pass the 100 mark for employees. Should you bother with a simple cafeteria plan if you foresee rapid growth? In later years, if you employ up to 200 employees, you’re still considered an eligible employer and can keep the simple cafeteria plan that you established when you had fewer employees.
Eligibility and participation requirements. These requirements are met if both of the following are met:
- all employees who had at least 1,000 hours of service for the preceding plan year are eligible to participate; and
- eligible employees who participate in the plan may elect any of the plan benefits available.
Employers do have the option of excluding the following employees from a simple cafeteria plan:
- Employees who are under 21 years of age before the close of the plan year.
- Employees who have less than a year of service with the employer as of any day during the plan year.
- Employees who are covered under a collective bargaining agreement.
- Employees who are nonresident aliens working outside the Unites States whose income did not come from a United States’ source.
Contribution requirements. Employers can meet the simple cafeteria plan contribution requirements by making a contribution to provide benefits to each employee who is not a highly compensated or key employee—known as a qualified employee—in an amount equal to:
- a uniform percentage (not less than 2 percent) of the employee’s compensation for the year, or
- an amount which is the lesser of:
- at least 6 percent of the employee’s compensation for the year, or
- twice the amount of each qualified employee’s salary reduction contributions not included in the employee’s gross income.
If the contribution amount is based on the second option, the rate of contribution to a highly compensated or key employee’s salary reduction contribution cannot be greater than the rate of contribution to other employees.
If you are considering a simple cafeteria plan, take into account the added benefit available to you if you are incorporated. Simple cafeteria plans provide a safe harbor from the majority of nondiscrimination rules stopping many small business owners from availing themselves of this benefit. However, only eligible owners of corporations are permitted to participate as employees. For other forms of organization, owners can provide the benefits for their employees and save on payroll taxes through employee salary reductions, but are not eligible to participate in the employee benefits offered through their plans.