Flexible Benefits for Small Employers

Cafeteria plans can help cut rising benefits costs. Small employers often face the difficult task of providing benefits to employees in a cost-effective manner. With health insurance premiums and other costs rising, many small businesses are forced to be creative or eliminate some benefits entirely. Since most owner/employees want to provide at least health insurance for themselves and their families--and usually for other employees--eliminating benefits generally is not an option. There is, however, an answer. Cafeteria plans under IRC section 125 and non-125 flexible benefit plans can help small employers provide necessary benefits in a way that helps mitigate rising costs. TAXABLE VS. TAX-FREE An employer can provide non-cash benefits to employees and usually deduct the cost. Some of them are tax-free, meaning the employee does not have to include the value in his or her taxable income. Among the benefits a company can provide tax-free are health insurance, medical expense reimbursement, dependent care reimbursement, disability insurance and long-term care insurance for the employee and his or her spouse and dependents. Employers are also permitted to make contributions to medical savings accounts (MSAs) and provide a limited amount of group term life insurance as well as provide certain fringe benefits (such as free employee parking). These benefits will be tax-free to the employee. Under the principle of constructive receipt, if the employer gives the employee a choice between tax-free benefits and cash or another taxable benefit, the employee must pay income tax on the cash (or the value of the other taxable benefit). The employee is taxed even if he or she chooses an otherwise tax-free benefit rather than the cash. The tax law treats the employee as if he or she had chosen the cash and then used it to buy the benefit independent of the employer. In such instances, the employee would have to pay tax on the cash. IRC section 125 outlines various requirements for plans, which let employees choose cash or some of the tax-free benefits mentioned above and avoid income tax on the chosen tax-free benefits. A section 125 cafeteria plan overrides the constructive receipt doctrine--only the cash actually elected is included in the employee's income. An employee may also elect to have his or her earnings reduced to pay for tax-free benefits over and above the amount the employer is willing to contribute. Indeed, many cafeteria plans are designed so an employee's pay is reduced to cover the entire cost of tax-free benefits--the employer contributes nothing. According to section 125's requirements, no more than 25% of tax-free benefits under a cafeteria plan may go to key employees. (Key employees are generally certain owners--even small-percentage owners if they are highly paid--and certain high-paid officers.) This means that for every $3 in tax-free benefits non-key employees receive as a group under a cafeteria plan, key employees together may receive $1 in tax-free benefits. As key employees typically have more income to spend on tax-free benefits than non-key employees, the 25% test often hampers key employees' ability to fully enjoy a cafeteria plan's tax savings. Typical situations in which the 25% concentration test poses a challenge include professional practices, such as doctors, lawyers or CPAs, and very small companies. These employers may find a cafeteria plan is often not worth the costs of design, documentation and administration--particularly if the ratio of non-key employees to key employees is not greater than 3 to 1. Section 125 and other IRC sections also prohibit cafeteria plans from offering some tax-free benefits, such as fringe benefits, long-term care insurance coverage and contributions to an MSA. MAXIMIZING ADVANTAGES FOR KEY EMPLOYEES To bolster the tax-free benefits of non-key employees, and thus the benefits key employees can elect, a company may have a cafeteria plan but provide health insurance coverage to key employees outside the plan. …