2018 UPDATE – Most small business employee benefit plans should be redesigned and amended for 2018 to maximum the tax advantages in responde to the changes of the Tax Cuts and Jobs Act. Ask us for a free review.
This information comes primarily from IRS Publication 15B titled “Employer’s Tax Guide to Fringe Benefits”. An annotated copy is available on our Web site to help answer common questions and serve as an additional resource. The material is abbreviated and formatted here in a way to highlight the issues that small business owners ask about most often.
This article is intended as a summary of information essential to a small business owner in understanding how today’s consumer-empowered health plans operate under the tax code. Many other aspects of wage and benefits tax reporting covered in Circular E are not covered in this summary article.
The article covers health plan taxation in three primary discussions:
General employee benefit tax treatment
For employers: Employers can usually deduct the full cost of employee health benefits as a regular business expense in the same manner as wages. The primary exception is when overall compensation (wages plus the value of benefits) is so high as to be deemed unreasonable compensation and therefore not an ordinary business expense.
For employees: As a starting point, recognize that all employee benefits, including the value of employee health plans, are taxable to the employee in the same manner as wages unless a specific provision of tax law applies to change the tax treatment. The remainder of this article focuses on the employer-paid benefits that are excluded from taxable compensation of the employees.
Benefits excluded from taxable earned income
The following benefits are generally excluded from taxable compensation sub subject to limitations and additional rules that apply to each type of benefit. These are known as “qualified benefits”. (This article skips most of the special rules for each type of benefit).
- Accident and health benefits
- Achievement awards
- Adoption assistance
- Athletic facilities
- De minimis (minimal) benefits
- Dependent care assistance
- Educational assistance
- Employee discounts
- Employee stock options
- Employer-provided cell phones
- Group-term life insurance coverage
- Health savings accounts (HSAs)
- Lodging on your business premises
- Meals
- Moving expense reimbursements
- No-additional-cost services
- Retirement planning services
- Transportation (commuting) benefits
- Tuition reduction
- Working condition benefits
Non-taxable employee health benefits
You can generally exclude the value of accident or health benefits you provide to an employee from the employee’s wages. If you pay the cost of an accident or health insurance plan for your employees, including an employee’s spouse and dependents, payments are not wages and are not subject to social security, Medicare, and FUTA taxes, or federal income tax. Generally, this exclusion also applies to qualified long-term care insurance contracts. (This rule also applies to owner/employees of C corporations).
The plan may be insured or noninsured and does not need to be in writing. A self-insured plan is a plan that reimburses your employees for medical expenses not covered by an accident or health insurance policy. (Note that health reform law did not change this basic provision of business tax law. This is a common are of misunderstanding even among professionals).
The exclusion for accident and health benefits also applies to amounts you pay to maintain medical coverage for a current or former employee under the Combined Omnibus Budget Reconciliation Act of 1986 (COBRA). The exclusion applies regardless of the length of employment, whether you directly pay the premiums or reimburse the former employee for premiums paid, and whether the employee’s separation is permanent or temporary. (See www.COBRAplan.com for more information).
The small business employer is not required to file a tax return (called a Form 5500) for the employee benefit plan. (See “Is a Form 5500 required?” for more information).
Taxable health insurance benefits
The value of health insurance must be included in the wages of S corporation owner/employees who own more than 2% of the S corporation. Special rules also apply to business owners who do not receive wages or a Form W2. (The exclusionary rules apply to partners, LLC or L3C members that are not considered to be employees for purposes of this area of tax law).
Employer-sponsored health plans
An employer-sponsored health plan is an arrangement that provides benefits for your employees (but not including owners), their spouses, their dependents, and their children (under age 27) in the event of personal injury or sickness. Employer-sponsored health plans are subject to additional rules (including Department of Labor requirements commonly known as ERISA) outside of the tax code.
(This article does not cover employer-sponsored health plan rules outside of the tax code nor the distinction between an “employer sponsored plan” and a health benefit provided outside of a plan. The sections below cover tax aspects only of employer-sponsored benefit plans).
Cafeteria Plans
A cafeteria plan, including a flexible spending arrangement (or FSA), is a written plan that allows your employees to choose between receiving cash (same as wages) or taxable benefits (note that the cafeteria plan itself does not make the benefits non-taxable) instead of certain qualified benefits for which the law provides an exclusion from wages. If an employee chooses to receive a qualified benefit (a tax-free benefit) under the plan, the fact that the employee could have received cash or a taxable benefit instead will not make the qualified benefit taxable.
(Notice that is the addition of the choice that now triggers additional tax compliance requirements like documentation and non-discrimination testing on an employee benefit that might have otherwise been tax-free without the need for additional requirements. This is the primary reason that small businesses have relied on only undocumented health insurance plans in the past for their employee health plans. Rising health costs, health reform laws and decreasing health plan administrative costs provide new incentives for small businesses to reconsider their choice and format of employee health benefits).
The Affordable Care Act introduced a new type of cafeteria plan called a Simple Cafeteria Plan that is discussed separately.
General requirements of cafeteria plans
Cafeteria plans must be in writing (called documentation requirements), information and reports must be distributed in a prescribed format to employees (called administrative requirements) and the plan must meet certain operational requirements with regard to eligibility (called eligibility requirements) and the distribution of benefits (called non-discrimination requirements).
No deferred compensation allowed
Generally, a cafeteria plan does not include any plan that offers a benefit that defers pay. However, a cafeteria plan can include a qualified 401(k) plan as a benefit. Also, certain life insurance plans maintained by educational institutions can be offered as a benefit even though they defer pay.
Qualified benefits
A cafeteria plan can include the following tax-free benefits:
- Accident and health benefits (but not long-term care insurance. Note that this benefit could be included as a tax-free benefit outside of a cafeteria plan).
- Adoption assistance.
- Dependent care assistance.
- Group-term life insurance coverage (both taxable and non-taxable).
- Health savings accounts (HSAs). (Note that distributions from an HSA may be used to pay eligible long-term care insurance premiums or qualified long-term care services).
(Note that cafeteria plans can and usually do contain options other than health benefits. Freedom Benefits standard free cafeteria plan designs for small businesses do include a range of other employee benefit options. This article only covers health benefits).
Disallowed benefits
Benefits not allowed in a cafeteria plan
A cafeteria plan cannot include the following benefits:
- Archer MSAs
- Athletic facilities
- De minimis (minimal) benefits
- Educational assistances
- Employee discounts
- Employer-provided cell phones
- Lodging on your business premises
- Meals
- Moving expense reimbursements
- No-additional-cost services
- Transportation (commuting) benefits
- Tuition reduction
- Working condition benefits
- Scholarships or fellowships
- Taxable benefits
Advantages of a cafeteria plan
A cafeteria benefit plan allows employers and employees to save money by lowering their wages taxes.
In rough figures – for discussion and financial planning purposes – the employer saves about 10% on every dollar an employee elects to place into a cafeteria plan and the employee saves an average of 20 to 30% of the amount of the election. For example, if an employee elects to pay $1,000 of dependent care expense through a cafeteria plan, the employer’s wage tax liabilities may drop by about $100 and the employee’s wage taxes may drop by about $250.
More detailed explanations and savings calculators are available from various sources, including the Summary Plan Description document available from Freedom Benefits.
Who is an “employee”?
Cafeteria plans treat the following individuals as employees:
1) common-law employee
2) A full-time life insurance agent who is a current statutory employee.
3) A leased employee who has provided services to you on a substantially full-time basis for at least a year if the services are performed under your primary direction or control.
(S corporation owners, shareholders, partners, members of an LLC and their family members are not considered employees for health benefit purposes or cafeteria plans).
Owner/employees or their family members may not participate
Do not treat a 2% shareholder of an S corporation as an employee of the corporation for this purpose. A 2% shareholder for this purpose is someone who directly or indirectly owns (at any time during the year) more than 2% of the corporation’s stock or stock with more than 2% of the voting power. Treat a 2% shareholder as you would a partner in a partnership for fringe benefit purposes, but do not treat the benefit as a reduction in distributions to the 2% shareholder. (Health Savings Accounts and employee benefits provided outside of a cafeteria plan are more useful to owner/employees).
Rules that limit usefulness of regular cafeteria plans
Cafeteria plans have special rules that limited their effectiveness when the benefits favor highly compensated employees or key employees. Even if the plan benefits do not favor these individuals, the required process of testing the plan is burdensome for small businesses. There is a potential total of nine separate tests for non-discrimination that may be required. A plan you maintain under a collective bargaining agreement (a union contract) is not affected by these rules.
If your plan favors highly compensated employees as to eligibility to participate, contributions, or benefits, you must include in their wages the value of taxable benefits they could have selected. A highly compensated employee for this purpose is any of the following employees: an officer, a shareholder who owns more than 5% of the voting power or value of all classes of the employer’s stock, an employee who is highly compensated based on the facts and circumstances, a spouse or dependent of a person described in this section. .
If your plan favors key employees, you must include in their wages the value of taxable benefits they could have selected. A plan favors key employees if more than 25% of the total of the nontaxable benefits you provide for all employees under the plan go to key employees. A key employee is generally an employee who is either of the following: an officer having annual pay of more than $165,000 or an employee who is either a 5% owner of your business or a 1% owner of your business whose annual pay was more than $150,000. These rules may change each year.
The Affordable Care Act limits the maximum annual employee contribution to a Flexible Spending Account (FSA) to $2,500 per employee per year. Only a maximum $500 of this contribution can be carried over to the following plan year so any unused portion of the employee contribution is forfeited to the employer. See IRS Notice 2013-71 for details on carry-over and “use it or lose it” features of a FSA.
Simple cafeteria plans
Eligible small business employers meeting employer contribution requirements and employee participation requirements can establish a simple cafeteria plan. This is a new benefit plan design option that became available in 2011 as part of the Affordable Care Act.
Advantages of a simple cafeteria plan
Simple cafeteria plans are treated as meeting all nondiscrimination requirements. Since the non-discrimination testing and compliance is avoided, presumably the cost and burden of running the cafeteria plan is lower. (Other than the issues described below, simple cafeteria plans operate the same as other cafeteria plans. See “Simple Cafeteria Plans” article for more information).
Disadvantage of a simple cafeteria plan
The most commonly noticed disadvantage among small employers is the required employer contribution. Regular cafeteria plans (other than simple cafeteria plans) do not require an employer contribution.
Eligibility requirement for a simple cafeteria plan
You are an eligible employer if you employ an average of 100 or fewer employees during either of the 2 preceding years. If your business was not in existence throughout the preceding year, you are eligible if you reasonably expect to employ an average of 100 or fewer employees in the current year.
Eligibility and participation requirements
These requirements are met if all employees who had at least 1,000 hours of service for the preceding plan year are eligible to participate and each employee eligible to participate in the plan may elect any benefit available under the plan.
You may elect to exclude from the simple cafeteria plan any employees who:
- Are under age 21 before the close of the plan year,
- Have less than 1 year of service with you as of any day during the plan year,
- Are covered under a collective bargaining agreement, or
- Are nonresident aliens working outside the United States whose income did not come from a U.S. source.
Contribution requirements for a simple cafeteria plan
You must make a contribution to provide qualified benefits on behalf of each qualified employee in an amount equal to:
1) A uniform percentage (not less than 2%) of the employee’s compensation for the plan year, or
2) An amount which is at least 6% of the employee’s compensation for the plan year or twice the amount of the salary reduction contributions of each qualified employee, whichever is less. Contributions made using this method may not favor highly compensated employees. If the contribution requirements are met using option (2) above, the rate of contribution to any salary reduction contribution of a highly compensated or key employee can not be greater than the rate of contribution to any other employee. More information. For more information about cafeteria plans, see section 125 of the Internal Revenue Code and its regulations. (We suggest that the equal percentage of compensation at 2% or higher as described in #1 above is a much easier and more practical contribution election for most small businesses).
(As a practical matter for planning purposes, we typically discuss 2% of payroll as being the estimated minimum cost of running a small business cafeteria plan).
Other Resources:
Annotated Employer’s Tax Guide (Publication 15 for 2012)
Annotated Employer’s Tax Guide to Fringe Benefits (Publication 15B for 2012)
Taxation of Health Insurance in 2014