Cafeteria plan

Cafeteria plan (also called a Section 125 plan or flexible benefit plan) is a type of employee benefit program authorized under Section 125 of the United States Internal Revenue Code that allows workers to choose from a menu of pre-tax benefits. The Revenue Act of 1978, signed into law on November 6, 1978, established the legal framework for these plans, which became effective January 1, 1979^[1]. Employees select benefits much like customers choose items in a cafeteria - hence the name.

Legislative history

Congress created Section 125 to make employee benefit programs more affordable for workers across income levels. Before 1978, employer contributions to flexible benefit plans were taxable to employees under constructive receipt doctrine. The Treasury Department worked with Congress during early 1978 to resolve this issue.

In exchange for favorable treatment of constructive receipt rules, Congress enacted non-discrimination provisions requiring employers to offer equal coverage choices to all employees^[2]. The Deficit Reduction Act of 1984 amended Section 125 significantly. This legislation restricted qualified benefits by excluding items such as employer-provided scholarships and group-term life insurance exceeding $50,000 coverage. It also introduced non-discrimination testing to prevent plans from favoring highly compensated employees.

Subsequent amendments occurred in 1980, 1986, 1988, and 1996. The Treasury Department issued proposed regulations on May 7, 1984, December 31, 1984, March 7, 1989, November 7, 1997, and March 23, 2000. Many tax professionals and Treasury officials came to view Section 125 as overly generous, and regulatory efforts attempted to limit revenue losses throughout the 1980s and 1990s.

Qualified benefits

A cafeteria plan must offer at least one taxable benefit (typically cash) and one qualified non-taxable benefit. The IRS recognizes several categories of qualified benefits^[3]:

Health-related benefits:

• Group health insurance premiums
• Health Flexible Spending Accounts (FSAs)
• Health Savings Account (HSA) contributions
• Dental and vision coverage

Dependent care:

• Dependent Care Assistance Programs (DCAPs)
• Adoption assistance programs

Other qualified benefits:

• Group-term life insurance up to $50,000
• Accident and disability coverage
• Supplemental insurance options

Certain benefits cannot be included in cafeteria plans. These exclusions cover deferred compensation arrangements, scholarships, educational assistance programs, employee discounts, and qualified transportation fringe benefits (though some transportation benefits may be offered through separate arrangements).

Tax treatment

Salary reduction contributions made through a cafeteria plan are neither actually nor constructively received by participants^[4]. This distinction creates substantial tax advantages:

• Contributions reduce federal income tax liability
• FICA taxes (Social Security and Medicare) are typically avoided on contributed amounts
• FUTA taxes do not apply to salary reductions
• Many states follow federal treatment, reducing state income tax as well

A worker earning $50,000 annually who contributes $5,000 to qualified benefits effectively receives those benefits at a 25-40% discount, depending on marginal tax rates. The employer also saves on payroll taxes, making cafeteria plans advantageous for both parties.

Plan requirements

Section 125 imposes several administrative requirements. The plan must be established and maintained in writing. Required plan document elements include^[5]:

• Specific description of each benefit offered
• Rules for eligibility and participation
• Procedures for making elections
• Statement that elections are irrevocable (with limited exceptions)
• Explanation of how employer contributions are made
• Plan year definition

Employers must conduct non-discrimination testing for most cafeteria plans. Three primary tests apply:

• Eligibility test - ensures reasonable percentage of non-highly compensated employees can participate
• Contributions and benefits test - verifies that highly compensated employees do not receive disproportionate benefits
• Key employee concentration test - limits benefits provided to key employees

Plans failing these tests must include excess benefits in the gross income of highly compensated or key employees.

Recent developments

The IRS announced significant changes in May 2005, allowing cafeteria plans to reimburse claims incurred up to 2.5 months after plan year close. Previously, reimbursements were permitted only for claims during the plan year itself. This grace period reduced the "use it or lose it" problem that discouraged FSA participation.

The Consolidated Appropriations Act of 2021 provided temporary COVID-19 relief, permitting carryover of unused FSA amounts and mid-year election changes. Some provisions were later made permanent through subsequent legislation.

Employer considerations

Companies implement cafeteria plans for multiple reasons. Cost containment ranks high - pre-tax contributions reduce employer payroll tax obligations. Recruitment and retention benefit from enhanced benefit packages. Workforce diversity often requires flexible options to meet varying employee needs.

Administration presents challenges. Third-party administrators handle most plans, charging per-employee fees ranging from $4 to $10 monthly. Compliance failures result in plan disqualification, causing all benefits to become taxable. Annual testing and Form 5500 reporting add administrative burden.

Major corporations including IBM, General Electric, and Procter & Gamble pioneered cafeteria plans during the 1980s. Today, the Society for Human Resource Management estimates that over 80% of employers with 500 or more employees offer some form of Section 125 plan.

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References

• Internal Revenue Code Section 125
• IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits
• Beam, B.T. and McFadden, J.J. (2020). Employee Benefits, 11th Edition. Dearborn.
• Society for Human Resource Management (2023). Employee Benefits Survey Report.

Footnotes

<references> <ref name="history">The Revenue Act of 1978 (Public Law 95-600) created Section 125, effective January 1, 1979.</ref> <ref name="congress">Congressional intent focused on improving benefit affordability for lower-paid workers.</ref> <ref name="qualified">IRS regulations define qualified benefits eligible for pre-tax treatment.</ref> <ref name="tax">Salary reduction contributions are excluded from gross income under IRC Section 125.</ref> <ref name="requirements">IRS Notice 2005-42 and subsequent guidance outline plan document requirements.</ref> </references>