The design and operation of cafeteria plans: the flexibility of benefits choice can enhance employee moral and after-tax income.

• Author: Hamill, James R.

The Flexibility of Benefits Choice Can Enhance Employee Morale and After-Tax Income

Cafeteria plans are a popular mechanism to provide fringe benefits to employees. They can be relatively simple, perhaps offering only the choice of cash or health insurance, or more complex, offering a wide variety of benefit options. To assist tax advisers and their clients in evaluating key aspects of existing plans or designing new plans to maximize the benefit to the employer and the employees, this article will discuss the design of key benefits, the structure of flexible spending accounts (FSAs) to minimize employer and employee risk of loss, and the essential administrative issues arising in the adoption and operation of a cafeteria plan.

Overview

Sec. 125(a) provides that a participant in a cafeteria plan can choose between the receipt of cash or qualified benefits without having to recognize income solely because of the ability to choose. Without Sec. 125, an employee given a choice between cash or the purchase of a fringe benefit would generally be considered to be in constructive receipt of the cash, even if the fringe benefit was selected. A cafeteria plan is one mechanism to permit such a choice without creating a constructive receipt problem.(1) If the plan is properly structured, employees selecting tax-free benefits will pay with pretax dollars, and those choosing cash will be taxed in the year of receipt.

The principal advantage of a cafeteria plan to employees is the ability to choose from a menu of offerings those benefits that are of greatest value to the individual. Employer administrative costs generally constrain the number of available choices. Noncash benefits selected by employees are exempt from Fedcral income tax,(2) and may also be exempt from state income tax. In addition, FICA taxes can generally be avoided for all benefits other than salary reduction contributions to a Sec. 401(k) plan.(3) The ability to avoid income and FICA taxes can make a cafeteria plan attractive to employees even if the plan limits the choice to cash or health insurance coverage. Of course, avoiding FICA taxes may not appear attractive to employees concerned about reduced social security payments in future periods.

Employers benefit from cafeteria plans to the extent that benefits choice enhances the ability to attract, retain and motivate employees. Adoption and operation of a plan will create administrative costs, but payroll tax savings for employer-paid FICA can assist in reducing these costs. Employer FUTA taxes can also be avoided, although employee wages are likely to exceed the maximum contribution base without the value of the fringe benefit.(4) Offering health benefits through a cafeteria plan increases employee awareness of the cost of the benefit, which can assist in containing costs. Finally, retirement plan contributions can be reduced, depending on how the compensation base for contributions is defined. Of course, the effect of reduced retirement contributions on employee satisfaction with the overall benefits package must be considered.

To qualify under Sec. 125, the plan must be in writing,(5) be limited to employees(6) and offer participants a choice between cash and qualified benefits.(7) Highly compensated participants are not eligible for protection from constructive receipt if the plan is discriminatory as to either eligibility to participate or contributions and benefits.(8) Also, key employees fail to qualify for the constructive receipt waiver if the concentration of nontaxable benefits provided to such employees exceeds 25 % of the aggregate nontaxable benefits provided to all employees.(9) Any nondiscrimination provisions applicable to a particular benefit must also be satisfied for the benefit selection to be nontaxable.

Structuring a Cafeteria Plan

Since the principal advantage of a cafeteria plan is the ability to tailor benefits to employee needs, it is important to select carefully which benefits to offer. The starting point is the menu of available choices, which includes any benefit excluded from income other than scholarships, educational assistance plans and Sec. 132 fringe benefits.(10) Sec. 401(k) plan contributions are the only permitted form of deferred compensation.(11) A simple plan could offer only cash or health insurance, permitting employees to purchase a needed benefit with pretax (income and payroll) dollars and minimizing the employer's administrative cost. If the employer can offer more choices, a survey of employee needs will assist in selecting benefits to include in the plan. Preferences of highly compensated and key employees should be separately identified when designing the choices to ensure that the plan does not fail the nondiscrimination or concentration tests.

* Health care benefits

Health benefits are a popular choice among employees, and thus are a logical benefit to be offered in the cafeteria plan. As mentioned earlier, offering a trade-off between health coverage and other benefits involves the employee in the cost of the health coverage, and can assist in controlling escalating costs. When communicating the effects of a choice of health insurance coverage in a plan, the employer should make employees aware of the Revenue Reconciliation Act of 1990 (RRA) amendments to the earned income credit, providing for a supplemental health insurance credit. The credit is available only for the cost of health insurance coverage that includes a qualified child.(12) The employee should be aware that the credit is not available for any costs paid for with pretax dollars.

* Dependent care assistance benefits

Sec. 129 permits an exclusion from income for employer-provided dependent care payments. The exclusion can be as large as $5,000, and applies to expenses incurred for the care of a dependent of the taxpayer who is under age 13 or for a dependent or spouse who is physically or mentally incapable of taking care of himself. The dependent care credit provisions place restrictions on who can be the care provider and set requirements for identifying the care provider. The exclusion is limited to the lesser of the earned income of the taxpayer or the taxpayer's spouse. The earned income limitation also applies to a spouse who is a student or incapable of his own care.(13)

Because Sec. 129(d)(4) denies the exclusion if more than 25% of the benefits are provided to more-than-5% owners of the business, a dependent care program is not likely to be beneficial in a closely held corporation if the purpose is to meet the needs of the principal owner. The benefit may still be offered in the cafeteria menu, but the principal owner may need to limit...