Section 125 Plans: Restrictions by Business Entity Type and Required Nondiscrimination Testing
Section 125 plans, sometimes referred to as “cafeteria plans,” permit employers to sponsor Premium Only Plans (POPs) and Flexible Spending Accounts (FSAs).
POPs allow employees to pay for health insurance premiums using pre-tax dollars. This reduces an employee’s net income and increases their take-home pay. Because of the pre-tax component, POPs also reduce the employer’s FICA and payroll taxes.
Health FSAs allow employees to elect a dollar amount at the beginning of the FSA plan year to pay for future medical expenses incurred throughout the plan year. Allowed expenses are listed under Internal Revenue Code 213(d). Health FSA plans have a “use-it-or-lose it” stipulation, where unused funds are forfeited at the end of the plan year. Because of this, employees must be mindful when making elections.
FSA plans also have a uniform coverage stipulation, which gives participants full access to use all elected funds on the first day of the plan year – even if the employee has not funded any, or has only funded some, of the elected FSA amount through payroll deductions at the time of use.
While employers ultimately set the amount employees may elect for FSAs, the maximum election amount can never exceed $2,650 for the 2018 year per IRS regulations. FSAs can be funded by the employee, employer, or a combination of both – and special limitations apply for funding employers. Most commonly, FSAs are fully funded by the employee.
Section 125 plans fall under Section 125 of the tax code, which contains many stipulations, some of which were discussed in last month’s WBCompliance column. This column supplements last month’s column, with even more information on these plans.
Section 125 plans have participation limitations dictated by business entity as follows:
- S-Corporations (S-Corps) – Owners are not eligible to participate. The owner’s spouse, children, parents, or grandparents are also unable to participate if they are employed by the company sponsoring the Section 125 plan.
- Limited Liability Corporations (LLCs) – Owners and/or partners owning an interest in the company are not eligible to participate. Eligible family members of the owner who work for the business are allowed to participate.
- Limited Liability Partnerships (LLPs) – Owners and/or partners owning an interest in the company are not eligible to participate. Eligible family members of the owner who work for the business are allowed to participate.
- Partnerships – Owners or partners owning an interest in the company are not eligible to participate. Eligible family members of the owner who work for the business are allowed to participate.
- C-Corporations (C-Corps) – There are no restrictions; owners and family as well as employees can participate, but the owner must be a W-2/common law employee. Excessive participation of these individuals in a Section 125 plan may cause the failure of certain mandated nondiscrimination tests.
- Sole Proprietor – Owners and/or partners owning an interest in the company are not eligible to participate. Eligible family members of the owner who work for the business are allowed to participate.
Section 125 plans must be tested annually to ensure compliance with IRS regulations. Generally, the Third Party Administrator (TPA) of the Section 125 plan will send these tests to employers to complete.
- Concentration Test: The total pre-tax deductions of key employees cannot exceed 25% of the total pre-tax deductions of all employees of the entire group. A “concentration test” ensures compliance with this rule.
-The definition of key employees is as follows:
1) An officer of the employer whose annual compensation exceeds $175,000
2) An individual who owns at least 5% of the organization
3) An individual who owns at least 1% of the organization, whose annual compensation exceeds $150,000
- The Eligibility Benefits Test: This test ensures the Section 125-sponsoring employer offers all benefits to an adequate number of employees, and does not discriminate in favor of highly compensated or “key” employees. Essentially, this test ensures the employer is not offering highly compensated or key employees a richer benefit than it is offering to the rest of the workforce.