Employers may be very surprised to discover that they have a cafeteria plan and do not even know it, or that they have a cafeteria plan that improperly offers certain benefits to their employees. As a result, they are serving their employees "taxic" waste, i.e., tax heartburn, rather than the "low-tax" cuisine they could be offering through the cafeteria plan's menu.
If you fit this description, take heart. All is not lost. If you want to continue to offer the same benefits to your employees, you may be able to do so with a properly implemented cafeteria plan. In this article, we will look at some of the common tax problems encountered when offering employees a menu of benefits and how to avoid them.
What Is A Cafeteria Plan?
A cafeteria plan is an employee benefit arrangement under which employees choose between certain benefits permitted under the Internal Revenue Code (such as health insurance) and cash (or a cash equivalent). What's so difficult? Well, if the arrangement is operated incorrectly, the IRS says that the employees must include the available cash in their gross incomes even if they elected what would otherwise be tax-free benefits. Keep in mind that unlike problems under qualified retirement plans, problems under cafeteria plans cannot be corrected under an IRS fix-it program. If operated correctly, however, the arrangement will result in both income and employment tax savings:
- The employee pays less income tax by buying benefits with pre-tax, not after-tax, dollars.
- Both the employer and the employee generally pay less employment tax on the amounts used to buy benefits.
How does an employer enjoy these savings and pass them along to the employees as well? By having a written plan that (i) meets the IRS's design standards of nondiscrimination in favor of highly compensated individuals and key employees and (ii) is operated in accordance with the IRS's operational standards. We won't bore you with all of these rules; however, we will point out a few as we discuss the problems that we frequently encounter.
The Informal Cafeteria Plan
We will call an employee benefit arrangement that triggers the cafeteria plan rules an "informal cafeteria plan" when the employer does not realize that it is sponsoring such a plan. Under these circumstances, the employer may unwittingly have created tax problems for itself and its employees.
How could this happen? A common situation is when the employer offers its employees a choice between more cash or health insurance. This choice could be given at various times during the period of employment or even when an employee is first hired. The IRS says this raises the red flag for employees unless the cafeteria plan rules are observed. For example, the IRS ruled in a private letter ruling that, in the absence of a cafeteria plan, an employee's choice between additional pay and health insurance coverage, when first offered a job, results in the inclusion of the extra pay the employee could have received instead of health insurance coverage in the employee's gross income. This means both higher income and employment taxes. Not only that, such an arrangement could also affect the taxation of employees who were not offered the choice, unless the employer and these other employees can prove that they had no choice.
Employers may also be surprised by the IRS's position on arrangements that allow an employee to apply unused paid time off credits to purchase health benefits. For example, under the facts of a 1992 private letter ruling, employees could elect to convert certain unused sick days into cash or forfeit that election by having the following year's unused sick days converted into credits under a medical expense account. The IRS ruled that an employee who elects to convert excess sick leave to the medical plan was merely assigning future income (the cash value of the excess sick leave) for consideration (the medical expense coverage), which is a taxable anticipatory assignment of income even though the income was used to purchase a nontaxable benefit.
The Improperly Run Cafeteria Plan
Under this scenario, let's suppose that instead of bumbling into having a cafeteria plan and then avoiding the problems described above, the employer tries to establish a cafeteria plan, but does so improperly through either bad design or operational defects. Here again, the employer may be serving taxic waste. Here are some examples.
Deferred Compensation On The Menu
One of the many requirements for a properly designed and operated cafeteria plan is that the employer cannot offer deferred compensation, except through a qualified cash or deferred arrangement under a 401(k) plan. We often see tax-exempt employers, for example, offering their employees a choice among cash, health insurance, or a contribution to their 403(b) tax-sheltered annuity or 457 plan, all under the same cafeteria plan. Wrong!! You've just given your employees a large helping of tax problems. The solution? Offer the choice between cash and health insurance under the cafeteria plan, and the choice between other cash and the deferred compensation under the deferred compensation plan. It sounds like splitting hairs, but remember that lawyers came up with this stuff!
Carryovers To Future Years
Another aspect of the IRS's "no deferred compensation rule" is that a cafeteria plan may not defer compensation by allowing an employee to carry over benefits from one year to another. For example, if the cafeteria plan offers a flexible spending arrangement (FSA) through which the electing employees are reimbursed for medical expenses not covered by their health insurance, they may not accumulate funds in one year in order to pay benefits in future years (with an exception for a grace period for up to 2-1/2 months into the next year if allowed by the plan). Instead, they must "use it or lose it" either by forfeiting the unused amounts (although this may be contrary to ERISA in the eyes of the DOL) or by the employer returning the unused amounts to the employees either in cash or through reduced premiums for the following year. How else might this problem arise? It could arise if your plan offers insurance with a savings feature (such as whole life insurance or possibly cancer insurance with a refund feature).
The Uniform Coverage Rule
We still encounter health FSAs that violate the IRS's uniform coverage rule. This rule requires the employees who participate in a health FSA, whether through a cafeteria plan or not, must have available the annual benefit amount during the entire year (less benefits already paid) regardless of the "premiums" paid by the employee at any point in time. Translation: suppose an employee elects a $2,400 health FSA for which the "premiums" are $200 per month paid through salary reductions twice per month. On January 31, after $200 has been paid, the employee incurs a $2,000 medical expense and then quits on February 1. The employer "loses" $1,800 because the employer must pay the whole bill.
A cafeteria plan that offers other permissible benefits (such as health insurance) may also allow employees to purchase additional vacation days through salary reductions. The tricky aspect here lies in the IRS's ordering rules that require an employee to use his/her non-elective vacation days first and then the elective days. Then, to the extent that the employee has any unused elective days, the employer may pay the employee the value of the unused days in exchange for such days, but only if the employee is cashed out on or before the earlier of (i) the last day of the plan year or (ii) the last day of the employee's taxable year. Sounds like a record keeping nightmare? It can be. Note, the cash outs are not income tax free as some employers have been misled into thinking.
Paying Insurance Premiums Through A Health FSA
It is improper to pay health insurance premiums through an FSA. The way around this, though, is to pay the premiums through the cafeteria plan's premium payment feature, rather than through a health FSA, and to follow the requirements set forth by the IRS in Rev. Rul. 61-146. Then, if the employee can provide sufficient proof that the premiums have been paid to the insurance company, everything is okay, relatively speaking.
Discrimination In Favor Of The Highly Compensated
While we are confident that no employer would intentionally set up a cafeteria plan that favors highly compensated individuals (Hah!), an employer may occasionally stumble into a discrimination problem by not observing certain rules. These rules require that individuals who are not the common law employees of the plan's sponsoring employer must be taken into account for employee benefit plan purposes either because (i) they work for a commonly owned employer (known as the "controlled group" rules), (ii) they work for an employer who provides services to or with the sponsoring employer, whether there is common ownership or not (the "affiliated service group" rules), or (iii) they are leased by their common law employer to the sponsoring employer (the "leased employee" rules). If the sponsoring employer's plan covers mainly highly compensated individuals (artfully defined by our Congress as including those who are "highly compensated") and ignores these "deemed" employees, the plan may be discriminatory. The result: tax problems for the highly compensated.
The Solution: A Formal Cafeteria Plan
The answer to these problems is often fairly simple: adopt a written cafeteria plan. And make sure the plan meets the IRS's plan documents requirements, nondiscrimination rules, and operational requirements. This process necessitates familiarity with the tax rules governing cafeteria plans and the benefits that may be offered (e.g., the nondiscrimination rules that govern medical plans that are not fully insured), including the controlled group, affiliated service group and leased employee rules.
Note that this (mind-numbing) process also necessitates a familiarity with ERISA's requirements governing plans offered through the cafeteria plan. For example, one or more of the plans may be "employee welfare benefit plans" under ERISA. These require plan documents, summary plan descriptions (SPDs), and, perhaps, the filing of Forms 5500 with the DOL each year.
A final word of caution: make sure you coordinate your cafeteria plan with your other benefit programs. For example, you might want to alter your retirement plan's definition of "compensation" so that employees who reduce their salary under the cafeteria plan do not lose retirement benefits.
Although cafeteria plans are quite beneficial to both employers and employees, you must make sure that they are designed, documented and run properly in order to reap the benefits. Otherwise, you and your employees will be dining on some serious taxic waste. In order to ensure your compliance with these rules, we recommend that you review all of your payroll and benefits practices to determine if you have any "informal" cafeteria plans. You should also test your formal cafeteria plans against the IRS's requirements.