Under the new Healthcare Reform package, and effective for taxable years beginning after December 31, 2010, small employers are now allowed to adopt new SIMPLE Cafeteria Plans. Under the new law, SIMPLE Cafeteria Plans will be deemed to meet nondiscrimination requirements as long as the plan sponsor meets certain eligibility, participation, and minimum contribution requirements. This “safe harbor” would also cover the non-discrimination requirements applicable to certain benefits offered under a cafeteria plan, including group life insurance, coverage under a self-insured group health plan, and benefits under a dependent care assistance program.
A Cafeteria Plan (as provided for under Internal Revenue Code Section 125) is an employer sponsored plan under which employees have the option of selecting benefits or cash. Employees can choose which tax free benefits fit their needs, or may instead elect to receive taxable cash payments in lieu of unselected benefits. For example, under a Cafeteria Plan, employees may use salary reduction to pay their share of premiums for health insurance provided by their employer, with these payments made on a pre-tax basis. Thus, a Cafeteria Plan provides tax savings to employee and employer alike by subtracting premiums from gross salary before federal income and Social Security taxes are calculated.
A Cafeteria Plan must be established in writing; it may not discriminate in favor of highly compensated participants and it may not favor key employees. In the past, these non-discrimination rules have discouraged small business owners from using Cafeteria Plans. Further, if the non-discrimination rules are violated the plan benefits provided to highly compensated or key employees must be taxed. Because of the potential for taxation of benefits provided by the plan, small employers—who may be more likely than larger employers to have a higher percentage of highly compensated employers—have tended not to provide Cafeteria Plans to their employees.
In sum, besides easing the administrative burden once faced by small businesses that sponsored a Cafeteria Plan, the Healthcare Reform package also provides a safe harbor to the discrimination requirements applicable to highly compensated and key employees.
Who qualifies for a SIMPLE Cafeteria Plan?
A small employer is defined as one with an average of 100 or fewer employees on business days during either of the two preceding years. If the employer was not in existence during the prior year, the determination is based on the average number of employees who are reasonably expected to be employed on business days during the current year.
Once the plan is established, the company will be deemed to meet the requirement even if it grows to employ more than 100 people in subsequent years; this window has been established to encourage employers to continue hiring. Finally, once employees number 200 or more, the business no longer qualifies for a SIMPLE Cafeteria Plan.
How does it work?
A SIMPLE Cafeteria Plan allows employees to use pretax funds to pay their portion of the health, vision, dental, and other employer-sponsored welfare premiums. The employer contribution must (a) equal a uniform percentage (not less than 2 percent) of the employee’s compensation for the plan year, or (b) equal a 200% match of the employee contributions up to 6% of the employee’s compensation for the plan year. The rate of match for highly compensated employees cannot exceed the rate of match for non-highly compensated employees.
Who is an eligible employee?
In order to meet nondiscrimination requirements, all non-excludable employees with at least 1,000 hours of service during the preceding plan year must be eligible to participate in a SIMPLE Cafeteria Plan.
An employer may elect to exclude employees who have not attained age 21 before the end of the plan year, have less than one year of service as of any day during the plan year, are covered under a collective bargaining agreement, or are nonresident aliens.
A plan may provide for a shorter period of service requirement for employees who are younger, if desired. Each eligible employee must be able to elect any benefit available under the plan under the same terms and conditions as those applied to all other participants.
Who can benefit?
If an employer offers such a plan, the plan is deemed to pass discrimination testing. In discrimination testing, highly paid executives and other key employees’ (as defined by regulations) benefits in the plan are compared to benefits provided to other employees who are contributing to the plan. If the plan does not pass certain threshold tests and therefore fails the test, benefits are refunded as necessary to the highly compensated employees and become taxable to them.
For companies with a greater number of higher-level employees, such as a physicians’ practice or a law firm, making the commitment to a SIMPLE Cafeteria Plan can allow key employees and executives to maximize their benefits by freeing them from discrimination testing.
Another incentive to employers is the savings on payroll taxes. In addition, because the IRS may provide its own checklist in order to implement these plans, employers will save on plan document costs as well.
Participation requires that employers make a minimum employer contribution, which means putting more dollars into the plan. With executives or key employees and discrimination testing issues, this slight drawback to the plan may be worth the investment.
What changes have occurred in Flexible Spending Accounts?
Nonprescription, over-the-counter drugs now require a doctor’s prescription if they are to be eligible for reimbursement in an FSA (or in a Health Savings Account or Health Reimbursement Arrangement). Further, the employer is responsible for compliance with these rules, which includes maintaining adequate records.
Also beginning in 2011, the penalties have increased from 10 percent to 20 percent if funds from a Health Saving’s Account are used for nonmedical expenses before age 65.
And beginning in 2013, the maximum reimbursement amount will be limited to $2,500 for FSAs as part of a Section 125 plan. Currently, there is no Internal Revenue Service (IRS) limit on the amount that employees can defer on a pretax basis into a Flexible Spending Account. Meanwhile, companies on average impose a $5,000 limit, generally because the employer can become responsible for paying this amount, as shown in this example: employee opts to defer $5,000, in January employee undergoes surgery and uses the funds; the employer must provide the funds, even though said funds have not been taken from employee’s paycheck yet. This scenario illustrates the problem which can arise when an employer reimburses an employee who then leaves the company before the funds can be collected through payroll contribution. By imposing a $2,500 cap, the plan generates the after-tax revenue while also presenting an opportunity for a cost savings to the employer.
Can employers navigate a SIMPLE Cafeteria Plan on their own?
Not advised! While eligible small employers should explore a SIMPLE Cafeteria Plan, navigating these complex Plans is best done with professional guidance. Employers without the services of a third-party administrator should consult with an attorney or certified public accountant (CPA) to help ensure that they are in compliance with the rules and understand the tax implications.
An excellent benefits delivery tool, a SIMPLE Cafeteria Plan helps employers provide tax free benefits to employees. The new Healthcare Reform legislation did not change current law, in which sole proprietors, members of limited liability companies (LLCs), partners in a partnership, and more than two percent shareholders of S corporations are precluded from participating in a Cafeteria Plan. These restrictions will continue to be a major impediment to small business use of Cafeteria Plans.