Cafeteria plans are regularly adopted by larger companies to allow employees to choose health care and other employee benefits that fit their needs from a menu of employer-sponsored benefits. Under Internal Revenue Code § 125, employers may offer cafeteria plan participants the choice to pay for health insurance coverage, dependent care costs and out of pocket medical expenses on a pretax basis for both income and payroll taxes. Thus, cafeteria plans offer employees the flexibility they desire and provide both employees and employers with needed tax breaks.
The traditional cafeteria plan, however, has not been desirable for small and family owned businesses due to restrictions on employee eligibility and discrimination in favor of key or highly compensated employees. First, under the eligibility rules, owner-employees (i.e. sole proprietors, partners in a partnership, members of an LLC, and individuals owning more than 2% of an S Corporation) are precluded from participating in a cafeteria plan. Additionally, and more importantly, a cafeteria plan cannot favor highly compensated employees as to eligibility to participate, contributions, or benefits and cannot allocate more than 25% of the total of nontaxable benefits provided for employees to key employees.
For 2014, a key employee is generally an employee who is either an officer who has annual pay of more than $170,000, an employee who is a 5% owner of the business, or an employee who is a 1% owner of the business with annual pay of more than $150,000. Because small and family owned businesses tend to employ a higher percentage of key and highly compensated employees, there has been little or no incentive to offer employee benefits through a cafeteria plan as a result of these nondiscrimination rules.
Congress recognized this shortcoming and, as part of the Affordable Care Act, amended the Internal Revenue Code to encourage small businesses to take advantage of cafeteria plans by creating a safe harbor for plans that qualify as simple cafeteria plans. Effective January 1, 2011, if an eligible employer satisfies certain participation and contribution requirements, its simple cafeteria plan will be deemed to meet the nondiscrimination requirements under the new safe harbor without conducting any testing. Although the amendment unfortunately did not change the cafeteria plan rules with respect to excluded owner-employees, there is still an incentive for these owners to provide benefits for their employees and save on payroll taxes through employee salary reductions.
What employers are eligible to adopt simple cafeteria plans?
Employers are eligible to adopt a simple cafeteria plan if they have employed less than 100 employees during either of the two preceding years. All part-time, seasonal, and leased employees are included in this employee count, as well as all employers under common ownership. Recognizing the need for growth, however, Congress provided that an employer that adopts a simple cafeteria plan while eligible will remain eligible until it employs on average 200 or more employees on the business days during the year. In the event that 200 or more employees are employed, the employer may offer the cafeteria plan through the end of the plan year, but then must either terminate the plan or conduct nondiscrimination testing outside of the simple cafeteria plan safe harbor.
Which employees must be allowed to participate?
All employees with at least 1,000 hours of service in the preceding year must be allowed to participate in the cafeteria plan and to elect any of the benefits offered under the plan. Provided that employees who are under age 21, have completed less than one year of service, are covered by a collective bargaining agreement, or are a nonresident alien may be excluded from participation. Self-employed individuals, partners in a partnership, members in an LLC, and more-than-2% S-corporation shareholders may not participate.
What must an employer contribute to the cafeteria plan?
In order for a simple cafeteria plan to qualify under the safe harbor, the employer must contribute qualified benefits equal to (1) a uniform percentage (not less than 2%) of the employee’s compensation for the plan year, or (2) an amount equal to at least 6% of the employee’s compensation for the plan year or twice the amount of salary reduction contributions of each qualified employee, whichever is less. If the employer elects the latter contribution, the rate of contribution to a key or highly compensated employee cannot be greater than the rate of any other employee.
Although the simple cafeteria plan law is not new, implementing regulations have been overlooked in the midst of the other changes under the Affordable Care Act. Therefore, very few employers have adopted simple cafeteria plans to date. That said, we expect the popularity of simple cafeteria plans to increase as small and family owned businesses look for additional ways to offer flexibility to and increase retention among their employees. Employers should be aware, however, that the “simple” name may be misleading and are advised to consult with employee benefits counsel before adopting any form of cafeteria plan.