Benefits

An Introduction to Cafeteria Plans: Permitted Tax-Exempt and Taxable Benefits

By definition, cafeteria plans allow employees to choose between cash and a variety of employer-provided benefits without having to include the value of their chosen benefits as taxable income. Cafeteria plans are popular because they allow employees to design individualized benefits programs that suit their own special needs.benefits

For example, an employee with a working spouse may choose to opt out of the health insurance plan if the spouse has a better health plan. The extra cash that then becomes available may be used to establish a reimbursement account for uninsured health expenses or childcare costs.

Code Section 125 provides protection from taxation on available cash that is not selected under a cafeteria plan. Section 125 contains many of the rules that govern cafeteria plans—including a special set of nondiscrimination rules that apply to benefits provided under them.

In addition, each nontaxable benefit offered under a cafeteria plan is subject to the exclusion limits, qualification tests, and nondiscrimination rules of the code section that provides the tax exclusion for that benefit. The mere fact that a benefit is offered under a cafeteria plan does not make the benefit exempt from taxation, nor does the satisfaction of all the rules specified by Section 125 guarantee that a particular benefit will be exempt from tax.

If a cafeteria plan violates the special rules of Section 125, a benefit that may be tax-exempt if offered outside a cafeteria plan could lose its tax exemption if it is offered inside the plan.

Here’s a brief rundown of permitted cafeteria plan benefits, both tax-exempt and taxable, courtesy of the Employer’s Handbook: Complying with IRS Employee Benefits Rules.

Permitted Plan Benefits

A cafeteria plan includes any arrangement allowing participants to choose among two or more benefits consisting of cash (which is broadly interpreted for this purpose to include a list of permitted taxable benefits, annual leave, sick leave, paid-time-off, and severance pay) and a series of other qualified benefits (covering specific benefits that are nontaxable under a tax code provision other than Section 125).

Without this safe harbor protection, a common legal principle called “constructive receipt” would apply to cafeteria plan participants on the value of the optional cash and taxable benefits, simply because the plan participants have a choice between taxable and nontaxable benefits. This safe harbor protection is available, however, only if the plan satisfies strict rules regarding permissible plan benefits, qualification requirements, and plan operations.

In addition, highly compensated participants lose the Section 125 protection from taxation if the cafeteria plan fails certain nondiscrimination tests.

The list of benefits that can be offered under a cafeteria plan includes both nontaxable qualified benefits and certain taxable benefits (including cash).

Permitted Tax-Exempt Benefits

The nontaxable benefits that can be offered under a cafeteria plan are:

  1. Accident and health plans, including plans that pay insurance premiums (including supplemental insurance policies such as cancer insurance) and health flexible spending accounts (subject to certain limits);
  2. Accidental death and dismemberment benefits and business travel accident insurance;
  3. Long-term disability or short-term disability insurance;
  4. Premiums for COBRA continuation coverage;
  5. $50,000 of group term life insurance;
  6. Dependent care assistance up to $5,000 each year (or $2,500 each year for participants who are married and file separately);
  7. Adoption assistance;
  8. Deferrals under Section 40l(k) qualified retirement plans (including after-tax employee contributions that are subject to Section 401(m));
  9. Contributions to health savings accounts;
  10. Any other tax-exempt benefit permitted under regulations; and
  11. Payment or reimbursement of substantiated individual accident and health insurance premiums.

The Internal Revenue Service (IRS) has warned employers about potential double-dipping arrangements involving fixed-indemnity or wellness benefits paid for by salary reduction under a cafeteria plan. Such fixed-indemnity payouts or wellness rewards must be included in taxable income.

Permitted Taxable Benefits

The list of taxable benefits that can be offered under a cafeteria plan is almost unlimited, provided that these benefits do not enable plan participants to postpone being taxed on their current salaries to a later calendar year.

This prohibition on benefits that defer the receipt of compensation is a long-standing requirement of Section 125. Under proposed regulations issued by the IRS in 2007, which remain in effect, any taxable benefits offered under a cafeteria plan must be treated as being purchased by the employee with after-tax contributions equal to the benefit’s full value at the time it is received by the employee.

If the plan requires employee contributions that are less than the full value of the benefit, plan participants must be taxed currently not only on their actual contributions, but also on any additional taxable value. This rule prevents participants in cafeteria plans from taking advantage of the year-end withholding rules that would otherwise apply to taxable noncash employee benefits.

If, by contrast, a cafeteria plan requires employee contributions that exceed the full value of the benefit, plan participants must be taxed on their actual contributions.

Most plans offer only the few limited types of taxable benefits that historically have been permitted as plan benefits. Those taxable benefits include:

  1. Group term life insurance that is either in excess of $50,000 or discriminatory;
  2. Dependent care assistance that is taxable because it exceeds the Section 129 dollar limit, is discriminatory, or is used for certain types of child care that are excludable—for example, overnight camp expenses and care of 13- or 14-year-old children;
  3. After-tax contributions to a qualified profit-sharing or stock bonus plan that is subject to the Section 401(m) nondiscrimination rules;
  4. Vacation days, if they cannot be used or cashed out in a subsequent plan year;
  5. Long-term disability coverage; and
  6. Any other benefit that does not defer the receipt of compensation.
JenJennifer Carsen, JD,is a Senior Legal Editor for BLR’s human resources and employment law publications, focusing on benefits compliance. In the past, she served as the managing editor of California Employer Resources (CER), BLR’s California-specific division, overseeing the content of CER’s print and online publications and coordinating live events and webinars for both BLR and CER.

Before joining CER in 2005, Ms. Carsen was a Legal Editor at CCH, Inc. and practiced in the Labor & Employment Department at Sidley & Austin, LLP in Chicago. She received her law degree from the New York University School of Law and her B.A. from Williams College. She is a member of the New Hampshire Bar Association.

Questions? Comments? Contact Jen at jcarsen@blr.com for more information on this topic.