Significant rising healthcare expenditures emphasize how important it is to keep up to date on cost-cutting alternatives.

As healthcare costs are one of the fastest growing outlays for employers, it pays to seek out alternatives to reduce expenditures, while still providing attractive benefits to employees. One of the more popular cost-cutting maneuvers is to establish a cafeteria plan for employee benefits. Organized under Section 125 of the Internal Revenue Code, cafeteria plans are often used, often misunderstood vehicles to provide both taxable and non-taxable benefits to employees. Many times, employers believe they have established cafeteria plans, only to find out years later that no plan was ever created.

A cafeteria plan is, by definition, a separate, written benefit plan under which employees have the option of choosing the benefits they desire. This highlights one of the more important, yet overlooked, aspects of a cafeteria plan. The plan must be written in order to be recognized by the Internal Revenue Service. In most cases, an attorney can provide a template plan that allows an employer to choose which benefits they would like to offer and set eligibility requirements for employees. Generally, a plan must offer at least one cash benefit and one qualified benefit, more commonly referred to as after-tax and pre-tax benefits. If a plan simply offers two pre-tax “qualified” benefits, the document does not meet the definition of a cafeteria plan. All pre-tax benefits are exempted from federal income tax, Illinois income tax, Social Security taxes, Medicare taxes, and federal unemployment taxes. Additional rules apply to Illinois unemployment taxes and should be reviewed carefully.

Regulations on cafeteria plans are fairly broad regarding which items may be qualified benefits. For example, health insurance, dependent care assistance, group term life insurance, accidental death and dismemberment insurance, disability coverage, and health savings account (HSA) contributions are all eligible benefits. Additionally, cafeteria plans can include some after-tax contributions to deferred compensation plans, such as a 401(k) plan. One caveat of including disability insurance as a qualified benefit is that if the premiums are paid with pre-tax dollars, the disability benefits will be taxable to the employee. It may be beneficial to pay the long-term and short-term disability premiums with after-tax dollars, thus exempting a future claim of benefits from being taxable to the employee. Including disability insurance premiums as after-tax contributions satisfies the cash benefit requirement. Additional cash benefits can include annual leave, sick leave or severance pay.

In addition to regulations on the type of benefits allowable in a cafeteria plan, the Internal Revenue Service also mandates that an employer must allow all employees within a designated class or classes to participate in a cafeteria plan. An employer or benefits provider must complete nondiscrimination testing on an annual basis. Employers are not allowed to discriminate in favor of highly compensated employees, officers or owners; however, an employer can require certain eligibility requirements be met by employees. For example, an employer may mandate an employee completes a minimum number of service hours to be eligible. Also, an employer may mandate an employee completes a certain number of years of employment, with a maximum of three, before being eligible to enter the plan. An employee who satisfies the requirements must be allowed to commence participation no later than the first day of the plan year after the requirements have been satisfied. Additionally, employers must offer an open enrollment period on an annual basis to allow employees to modify participation in the plan.

Additionally, some extra work is involved with setting up your payroll system to correctly treat pre-tax and after-tax items. While many payroll systems accommodate these types of items, it is advisable to consult with your accountant to ensure payroll taxes are properly calculated. In general, employees must make an irrevocable election of benefits on an annual basis. Only a change in status allows the employee to change their election of benefits. HSA included in cafeteria plans are an exception to the annual basis. In these cases, an employee must have the right to change or revoke salary reductions on at least a monthly basis. However, employees are only able to change or revoke salary reductions a maximum of one time per month. While many companies require elections be made on paper documents, there is a movement toward using electronic means to satisfy election requirements. The IRS has permitted the use of electronic means as a safe harbor for qualified plan elections.

On March 30, 2010, President Obama signed the Health Care and Education Reconciliation Act of 2010. This legislation brings about sweeping changes to the healthcare system in America. Among those changes is an exception allowing small employers to satisfy nondiscrimination rules by providing a simple cafeteria plan to employees. In a simple cafeteria plan, an eligible employer must employ an average of less than 100 employees during the prior two years. Additionally, employees who have at least 1,000 hours of service during the preceding plan year may elect any benefit available within the plan. These cafeteria plan changes are applicable to plans beginning after December 31, 2010.

Significant rising healthcare expenditures emphasize how important it is to keep up to date on cost-cutting alternatives. Cafeteria plans, while providing significant tax benefits, also provide a wealth of opportunities for errors. Determining the structure of your plan, maintaining the plan document for any legal or structural changes, and determining which benefits to provide to employees should be decisions made in association with your benefits provider, accountant and attorney. As Congress passes sweeping healthcare legislation, more opportunities for cost cutting seem likely while additional rules and regulations are a certainty. iBi