December 19, 2007
SECTION 125 CAFETERIA PLANS
By: Janet L. Kaminski Leduc, Associate Legislative Attorney
You asked if Section 23 of PA 07-185, regarding Internal Revenue Code Section 125 “cafeteria plans,” applies to employers of all sizes; if there was any public hearing testimony on this topic; if Massachusetts has the same requirement; and what an employer needs to do to establish a cafeteria plan.
The Office of Legislative Research is not authorized to render legal opinions and this report should not be considered one.
A “cafeteria plan” is a fringe benefit plan that complies with Section 125 of the Internal Revenue Service (IRS) code. The plan must be in writing and permit participating employees to choose among two or more benefits consisting of cash (salary), taxable benefits, or certain qualified non-taxable benefits, such as health insurance. Failure to satisfy Section 125 requirements could mean plan disqualification, in which case, employees' payroll deductions will be treated as taxable income.
Section 23 of PA 07-185 requires employers that provide health insurance to their employees, for which the employees make premium contributions through a payroll deduction, to let the deductions be taken on a pre-tax basis at the employees' option. In essence, then, it requires these employers to set up and maintain a “cafeteria plan” in accordance with Section 125 of the federal Internal Revenue Code.
The state law applies to employers of all sizes, but does not apply to employers that self-insure medical benefits for their employees. Under the federal tax code, certain individuals, including sole proprietors, are not eligible for coverage under a cafeteria plan.
Several proposed bills that received public hearings during the regular 2007 session included the concept ultimately enacted as Section 23 of PA 07-185. But, very little testimony was specific to the cafeteria plan requirement.
Massachusetts has a different requirement regarding Section 125 cafeteria plans. It requires employers with 11 or more full-time equivalent employees working in Massachusetts to (1) adopt and maintain a cafeteria plan that satisfies Section 125 requirements and regulations the Commonwealth Health Insurance Connector Authority (the Connector) promulgates and (2) file a copy of its cafeteria plan with the Connector upon request. If an employer subject to the requirement does not comply, it may have to pay the commonwealth a surcharge to cover a portion of any uncompensated care that its uninsured employees receive.
The most basic type of cafeteria plan that allows for pre-tax health insurance premium contributions is a “premium only plan.” However, due to the complex regulations governing cafeteria plans, employers may need legal, human resource, and payroll personnel who are well versed in Section 125 plans. Based on an online search, it appears that numerous consulting firms offer administrative services for such plans.
More details regarding Section 125 cafeteria plans follow below. In addition, we have enclosed the Massachusetts Connector's “Section 125 Plan Handbook for Employers,” which is available on their website at www.MAhealthconnector.org.
Section 23 of PA 07-185, effective October 1, 2007, says:
Any employer that provides health insurance benefits to its employees for which any portion of the premiums are deducted from the employees' pay shall offer such employees the opportunity to have such portion excluded from their gross income for state or federal income tax purposes, except as required under Section 125 of the Internal Revenue Code of 1986, or any subsequent corresponding internal revenue code of the United States, as from time to time amended.
Therefore, if an employer (1) provides health insurance benefits to its employees, (2) requires the employees to pay a portion of the premiums, and (3) collects the employee contributions through a payroll deduction, then the law requires the employer to allow its employees to make the deduction on a pre-tax basis. If the employees elect the pre-tax contribution option, then it appears that the employer has to set up and maintain a “cafeteria plan” in compliance with Section 125 of the IRS code.
The law does not exempt from its requirement an employer of a certain size (e.g., employers with 50 or fewer employees). Therefore, as written, the law applies to employers of all sizes.
But, it also appears that the new law does not apply to an employer that (1) pays the full cost of its employees' health insurance, (2) self-insures a medical benefit plan for its employees, or (3) does not provide health insurance benefits to its employees.
Public Hearing Testimony
PA 07-185 originated as emergency-certified SB 1484. As such, it did not receive a public hearing. However, several bills considered in the 2007 regular legislative session contained the same requirement as § 23 of PA 07-185, including SB 1 (§ 21) raised by the Public Health Committee; SB 1349 (§ 10) from the Insurance and Real Estate Committee; and HB 7314 (§ 10) from the Labor and Public Employees Committee. These bills had public hearings on January 31, March 6, and March 8 respectively, though there was little mention of the Section 125 IRS code language.
In his written testimony on HB 7314, Frances G. Padilla of the Universal Health Care Foundation of Connecticut indicated that “the language concerning Section 125 of the Internal Revenue Code may need fine-tuning.” Stan Dorn of the Urban Institute made the same comment in his written testimony on SB 1349. However, neither Mr. Padilla nor Mr. Dorn provided a specific recommendation for rewording the section.
During the hearing on SB 1349, Representative Linda Schofield asked Mickey Herbert, President and CEO of ConnectiCare, how much of a burden it is on employers to establish a Section 125 cafeteria plan to have employee contributions taken on a pre-tax basis. Mr. Herbert responded that establishing a cafeteria plan “probably is a good idea,” but that he does not consider himself “enough of an expert to comment.”
As part of its health care reform initiatives enacted in April 2006, Massachusetts mandated that employers with 11 or more employees set up Section 125 cafeteria plans by July 1, 2007. Specifically, the law required employers “with more than 10 employees in the commonwealth” to (1) “adopt and maintain a cafeteria plan that satisfies 26 U.S.C. 125” and regulations the Commonwealth Health Insurance Connector Authority (the Connector) promulgates and (2) file a copy of its cafeteria plan with the Connector.
Effective November 29, 2007, the law was revised. It now requires “each employer with 11 or more full-time equivalent employees in the commonwealth” to (1) “adopt and maintain a cafeteria plan that satisfies 26 U.S.C. 125 and the regulations promulgated by the Connector” and (2) “provide a copy of the cafeteria plan if requested by the Connector” (Mass. Gen. Laws Ann. ch. 151F, § 2). (We have enclosed a copy of the final regulations, Mass. Regs. Code tit. 956, §§ 4.00 – 4.08.)
For this purpose, "employer" does not include a sole proprietor or tax exempt organization, as described in 26 U.S.C. 501, that is exclusively staffed by volunteers (Mass. Gen. Laws Ann. ch. 151F, § 1).
The Massachusetts' requirement applies to employers whether or not the employer pays any part of the health insurance premium. And, the right to participate in the Section 125 plan extends to employees whether or not they are eligible for the employer's health plan. An employee may use the employer's payroll deduction to purchase individual Commonwealth Choice coverage, which the Connector and commercial health plans offer, with pre-tax dollars.
Employers with 11 or more full-time equivalent employees that do not offer a Section 125 Plan may be subject to a “free rider surcharge” if employees receive state-funded health services. State-funded services are emergency medical services that the state pays for out of the “free care pool,” which reimburses hospitals and health centers for the care they provide to uninsured patients.
The regulations require that the Section 125 Plan be, at minimum, a premium-only plan offering access to one or more health coverage options in lieu of regular cash compensation. And, Section 125 Plans that function only as flexible spending account plans, or as premium-only plans offering access to benefit options that do not include access to any health care coverage options, will not satisfy the requirement.
According to the Massachusetts Taxpayers Foundation, a high level of compliance with the requirement is expected because of the tax savings Section 125 plans offer. Further:
The Connector is making every effort to help companies set up new Section 125 payroll deduction plans, but the regulations governing the plans are complex, and even employers that already offer the plans may need to redesign them or extend them to certain employees that had previously been ineligible to participate. Small companies, in particular, may need to develop or purchase new legal, human resource and payroll services in order to comply (Massachusetts Taxpayers Foundation, An Analysis of the Essential Role of Employers in Massachusetts Health Care Reform, Dec. 2007, p. 10).
SECTION 125 CAFETERIA PLAN
Favorable Tax Treatment
Under Section 125 of the IRS code, employers can set up cafeteria plans that allow employees to choose from a menu of benefits, including cash, taxable benefits, and certain qualified benefits that the tax code exempts from taxes, such as health insurance. An employee participating in a cafeteria plan who enrolls in the employer's health insurance plan and agrees to pay any required premium contribution through payroll deduction does not pay income or Social Security taxes on the deducted amount. The employer also receives a tax benefit, since the law exempts the employee's payroll deduction from employer payroll taxes.
For example, in Massachusetts, an employee participating in a cafeteria plan can save from 28% to 48% of their premium contributions, depending on their federal tax bracket, and employers can save 7.65% on their share of payroll taxes (Massachusetts Taxpayers Foundation, An Analysis of the Essential Role of Employers in Massachusetts Health Care Reform).
Definition and Requirements
A cafeteria plan is a fringe benefit plan that complies with Section 125 of the IRS code. The plan must be in writing and permit participating employees to choose among two or more benefits consisting of cash, taxable benefits, or qualified non-taxable benefits. It excludes deferred compensation plans, except for qualified 401(k) plans and certain life insurance plans educational institutions offer.
Failure to satisfy Section 125 requirements could mean plan disqualification, in which case, employees' payroll deductions will be treated as taxable income.
Under Section 125, employers wanting to sponsor a cafeteria plan must:
1. establish a plan in writing and set a plan effective date;
2. distribute a summary plan description (SPD) to each participating employee;
3. have employees make their plan election and authorize the employer to withhold the employee premium contribution pre-tax;
4. keep plan documents, the SPD, and signed employee election and authorization forms on file for review or audit by the IRS or Department of Labor;
5. advise its payroll department to deduct participating employees' contributions pre-tax as of the plan's effective date;
6. if the plan is a flexible spending account for more than 100 participants, file “Form 5500” annually with the IRS;
7. provide participating employees a new SPD whenever the plan changes and at least once every five years; and
8. conduct nondiscrimination testing annually to make sure the plan does not discriminate in favor of highly compensated or key employees.
Written Plan Document. The plan must be in writing and may consist of one or more documents. This written plan document must be signed by an authorized company officer, or otherwise adopted, before the plan's initial effective date. It must specify the plan year and include or incorporate by reference:
1. a description and the coverage period of each benefit available under the plan;
2. the plan's participation eligibility rules;
3. the process by which employees may elect to participate, including the election period, the extent to which elections are irrevocable, and the period for which the election is effective;
4. how contributions to the plan are made (e.g., salary reduction, employee bonuses, taxable employer contributions); and
5. the maximum dollar amount or compensation percentage that an employee may contribute to the plan.
Employees. All plan participants must be employees of the sponsoring employer. The plan must be primarily for the benefit of current employees, but may also cover former employees. An employee's spouse and other beneficiaries are not plan participants, but may receive benefits under the plan.
Certain individuals are not eligible to participate in a cafeteria plan. For example, self-employed individuals, partners, and 2% owners of subchapter S corporations cannot be covered under a cafeteria plan. (A 2% owner is someone who directly or indirectly owns more than 2% of the corporation's stock or stock with more than 2% of the voting power. A subchapter S corporation is a corporation that, for tax purposes, chooses to be treated as if it were a partnership; this allows profits and losses to pass through to individual shareholders, who report the income or loss on their individual income tax returns.)
According to IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits (February 2007), qualified benefits for a cafeteria plan include:
1. accident and health benefits, except long-term care insurance;
2. adoption assistance;
3. dependent care assistance;
4. group term life insurance (including that portion for which costs cannot be excluded from wages because it exceeds the limit set in I.R.C. § 79); and
5. health savings accounts.
But, a cafeteria plan cannot include the following benefits, among others:
1. long-term care insurance,
2. Archer medical savings accounts,
3. athletic facilities,
4. educational assistance or tuition reduction,
5. employee discounts,
6. moving expense reimbursements,
7. transportation (commuting) benefits, and
Types of Cafeteria Plans
There are three main types of cafeterias plans an employer can establish: premium-only plan, flexible spending account, and full cafeteria plan.
Premium-Only Plan (POP). A POP plan is the simplest Section 125 plan to set up and maintain. It lets employees make contributions to health insurance and term life insurance with pretax dollars through payroll deductions.
Flexible Spending Account (FSA). An FSA lets employees contribute pre-tax dollars to an account the employer manages. The account may be used to pay for certain dependent care and medical expenses the employee incurs during the plan year that are not covered by insurance.
Before the plan year begins, an employee elects an amount of salary to be set aside each pay period on a pre-tax basis. Each pay period, the employer deposits that amount into an account for the employee's use. When the employee incurs an expense not paid for by insurance (e.g., a deductible or copay), he pays the amount out-of-pocket then submits a claim and expense documentation to the employer (or account administrator) who reimburses the employee from the account. Thus, the employee is able to pay for the expenses using pre-tax dollars. However, an employee forfeits any money remaining in the account at year end; this is referred to as the “use-it-or-lose-it” rule).
Full Cafeteria Plan. A full cafeteria plan (sometimes referred to as a full flex plan) includes a full array of employee options and generally includes pre-tax health care contributions, FSAs, and additional flexible benefit credits. Employees receive a lump sum of credits to spend on a variety of benefits in any combination they choose. Any credits not used to purchase benefits are returned to the employees' salary as taxable income.
A full cafeteria plan is the most complex plan to administer and only very large employers usually set up one.
Highly compensated employees and key employees' payroll deductions for health insurance premium contributions are subject to tax unless certain nondiscrimination rules are satisfied. If the highly compensated employees' or key employees' benefits do not satisfy the nondiscrimination rules, then the employee's deduction is taxed and the employer is liable for withholding taxes and penalties for late payment of such taxes.
A cafeteria plan maintained pursuant to a collective bargaining agreement automatically satisfies the nondiscrimination tests.
In addition, separate nondiscrimination rules apply to certain underlying benefits under a cafeteria plan (e.g., FSAs and group term life insurance). Adoption assistance benefits and health benefits for which risk is shifted to an independent third party are not subject to nondiscrimination rules.
Safe Harbors. There are three safe harbors under the tax law for satisfying the nondiscrimination rules for eligibility: (1) the cafeteria plan benefits an employee group that constitutes a nondiscriminatory classification of employees, (2) no more than three years of employment is required for participation in the cafeteria plan and the employment requirement is the same for all employees, and (3) each eligible employee is covered under the cafeteria plan on the first day of the plan year following his or her eligibility date (26 U.S.C. § 125(g)(3)).
Highly Compensated Employee. A highly compensated employee is (1) an officer, (2) a shareholder owning more than 5% of the voting power or value of all classes of an employer's stock, (3) highly compensated, or (4) a spouse or dependent of such person.
Key Employee. A key employee is (1) an officer with annual compensation above $130,000, (2) a 5% owner of the employer, or (3) a 1% owner of the employer with compensation over $150,000. No more than 50 employees or, if less, the greater of three or 10% of employees, may be considered officers.