Section 125 plans (sometimes referred to as cafeteria plans) offer a great way for employers and employees to reduce their tax liability while also offering benefits to employees. Unfortunately, some individuals and businesses take advantage of the complexity of the U.S. tax code by promoting “wellness savings” and “FICA tax credit” plans that claim to reduce tax liabilities but fail to meet the requirements to qualify as a cafeteria plan.
If you want to offer a Section 125 plan, you need to ensure you set up the plan correctly, work with a qualified administrator, and understand the rules. But that can be challenging – especially when unscrupulous promoters abuse the rules.
The goal of this blog post is to discuss the basics of Section 125 plans and identify ways in which promoters might try to trick your business into signing up for one of their plans that don’t meet Section 125 requirements. To get guidance now, contact Wiggam Law today so our experienced employment tax professionals can help your organization offer the best workplace benefits without running afoul of the IRS.
Key Takeaways
- Section 125 plans – Sometimes referred to as cafeteria plans, these are employment benefit plans created under Section 125 of the Internal Revenue Code.
- How cafeteria plans work – Pre-tax dollars are used to pay for benefits, so employers and employees enjoy reduced payroll taxes.
- Plan requirements – Section 125 plans can’t discriminate in favor of key or highly paid employees, employees must be able to choose from a taxable benefit and at least one qualified benefit, and employees must always substantiate their costs before receiving reimbursement payments.
- Benefit plan abuse – Some benefit plan promoters will give the impression that their plans offer tax savings in return for a fee, but in reality, many of these plans don’t meet Section 125 plan requirements.
- Employers can protect themselves – It’s best to talk with a tax professional before signing up for a benefit plan, especially one that pays out cash reimbursement benefits without requiring employees to substantiate their out-of-pocket costs.
What Is a Section 125 Plan?
Section 125 plans are employee benefit plans created under Section 125 of the Internal Revenue Code (IRC). Sometimes referred to as cafeteria plans, these plans allow employees to choose from multiple benefit options and use pre-tax income to pay for the benefits.
How Section 125 Plans Work
Because pre-tax dollars are used to pay for benefits, employers enjoy reduced employment taxes. Employees also have tax advantages, including reduced employment and income taxes.
The pre-tax contributions spent on Section 125 plan benefits are neither constructively nor actually received by the employee. Therefore, the IRS doesn’t usually consider that money subject to federal income, FICA (Federal Insurance Contributions Act), or FUTA (Federal Unemployment Tax Act) taxes.
Types of Section 125 Plans
There are many different types of Section 125 plans, but some of the most common include:
- Flexible spending accounts (FSA)
- Premium only plans (POP)
- Simple cafeteria plans
- Dependent care assistance plans (DCAP)
What a Legitimate Section 125 Plan Looks Like
A benefits plan that complies with Section 125 will have a plethora of requirements, with the most notable being:
- There are written plan documents that outline the plan’s requirements, such as eligibility, benefits offered, how contributions can be made, and available elections.
- The benefits can’t discriminate in favor of highly compensated or key employees, and there must be regular nondiscrimination testing rules in place to confirm that this discrimination doesn’t occur.
- The employees can’t be allowed to change their benefit elections until the next open enrollment period, except under certain circumstances, such as a change in family conditions, like a divorce or the birth of a child.
- The employer must employ an average of 100 or fewer employees during either of the previous two years (this requirement only applies to simple cafeteria plans).
- Employees must be able to choose from at least two different benefits, with at least one being a taxable benefit (such as cash) and one being a qualified benefit.
A qualified benefit can include:
- Health savings accounts
- Group-term life insurance
- Dependent care assistance
- Adoption assistance
- Health benefits (including vision, dental, and medical insurance)
- Accident benefits
Qualified benefits don’t include:
- Tuition assistance programs
- Transportation or other commuter benefits
- Certain fringe benefits
- Long-term care insurance coverage
If a claimed cafeteria plan has any of the following characteristics, it’s probably not a qualified Section 125 plan:
- The plan only offers choices between two or more taxable benefits.
- The plan exists primarily to offer benefits to former employees.
- The plan offers benefits that simply defer receipt of compensation (exception: 401(k) retirement benefits).
- The plan offers advanced reimbursements for medical expenses (exception: in some situations, FSA can allow this).
How Promoters Abuse IRS Rules
One way promoters take advantage of employers and employees is by offering benefit plans that seemingly comply with Section 125 but lack substantiation requirements. At first glance, the plan appears legitimate, with both employers and employees enjoying tax savings and employment benefits that appear to pay for themselves. But ultimately, it doesn’t pan out that way.
Let’s take a step-by-step look at how some of these schemes work.
Step 1: An Employer Signs Up for a “Wellness” Plan
The promoter offers a health or wellness plan to an employer in return for a fee. This health plan uses pre-tax contributions from employee paychecks to allegedly pay for wellness or health benefits.
Step 2: The Employer and Employee Enjoy Tax Savings
Because pre-tax dollars are being used to pay for the benefits, employers initially see lowered payroll taxes while employees see less tax withheld from their paychecks each pay period and potentially more take-home pay.
Step 3: The Pre-Tax Contributions Get Returned to Employees as Cash Payments
Depending on plan details, employees might receive cash reimbursement for healthcare costs incurred under the plan. Yet there’s minimal expense substantiation required, assuming any substantiation is required at all.
For example, an employee might be reimbursed for medical services, but the employee doesn’t have to provide documentation to prove how much they spent and/or what medical services they received.
Alternatively, the employee might receive cash reimbursement for certain expenses that aren’t eligible qualified benefits under Section 125, such as gym memberships. However, the promoter has implied that such benefits are available under this particular Section 125 plan and not taxable as wages.
Step 4: The Promoter Claims the Money Returned Isn’t Subject to Taxes
When an employee receives reimbursement under the plan, they’re told that the payment won’t be considered taxable income by the IRS. As a result, the employee’s net take-home pay is generally unchanged or slightly higher than before they signed up for the promoter’s plan. Despite this, the employee has received real benefits, such as access to healthcare or wellness services at either no cost to them or with a slightly bigger paycheck.
As for the employer, the fee they paid the promoter is comparable to, or less than, the money they saved on payroll taxes. As a result, the employer believes they were able to provide health or wellness benefits for their employees at little to no cost to the employer.
Step 5: The Employer and Employee Get a Reality Check
However, if the IRS audits the plan and determines it doesn’t meet the requirements to qualify under the Section 125 rules, the employer and their employees will incur tax and penalties, and the employer may face additional consequences.
Because the promoter’s plan didn’t fully comply with Section 125, the pre-tax contributions typically end up being taxable, so the IRS reclassifies them as wages. Or, even if the pre-tax contributions aren’t taxable, the IRS may consider the cash payments the employees received pursuant to the benefit plan as taxable income.
Legitimate Section 125 Plan vs. Promoter Plan
| Feature | Legitimate Section 125 Plan | Promoter “Wellness” or “FICA Credit” Plan |
|---|---|---|
| Legal basis | IRC §125, §105, §106, §213(d) | Marketing structure not recognized by the IRS |
| Benefit type | Health, dental, vision, FSA | Telehealth, gift cards, “preventive care” |
| Documentation | Written plan, substantiated expenses | Generic PDFs with code citations |
| Employee election | Voluntary, for qualified benefits | Mandatory or disguised payroll deduction |
| IRS compliance | Reduces taxable wages legitimately | Creates payroll-tax risk |
| Risk | Low | High — IRS may reclassify deductions as wages |
How Employers and Employees Are Left Having to Pay the Price
In the end, the employers and employees are liable for noncompliant Section 125 plans, meaning you’ll receive surprise tax bills for unpaid employment and income taxes. To make matters worse, penalties and interest will likely apply.
In many cases, neither the employers nor the employees can legally blame the promoters because there was probably some fine print somewhere stating that the information the promoter provided didn’t constitute tax advice. There might also be a provision in the plan documents that states the hypothetical scenarios presented in the marketing materials were for “illustrative purposes only” or that “benefits paid under this plan may be considered taxable income by the IRS.”
How Employers Can Protect Themselves
The best way to confirm whether a benefit plan complies with Section 125 of the IRC is to talk to a tax professional with experience dealing with cafeteria plans and payroll taxes. However, the following are red flags to look for when presented with a benefits plan that someone claims is Section 125 compliant:
- Marketing materials include fine print that indicates plan benefits could be subject to income and payroll taxes.
- The promotional materials use unusual or strange acronyms not commonly found on websites that discuss Section 125 cafeteria plans.
- The benefits offered are vague or seem too good to be true.
- There are no substantiation requirements when it comes to employees being reimbursed for expenses related to plan benefits.
- The plan offers substantial gift cards and other non-cash “rewards” as benefits to employees.
- Any citations or references to the IRC or IRS regulations can’t be found online, or don’t seem to have any relation to cafeteria plans or what the IRS considers taxable and nontaxable income.
- Participation in the plan is mandatory for employees.
- Employees have no opportunity to choose the benefits they want.
Wiggam Law Can Help With Section 125 Compliance
Trying to understand how cafeteria plans work under Section 125 of the IRC is a daunting task. So it’s not surprising that an employer might mistakenly sign up for a benefit plan that doesn’t comply with IRS rules.
Before agreeing to use a plan offered by some promoter, discuss your employment benefits and payroll tax needs with Wiggam Law. Our tax professionals can help you avoid expensive payroll tax problems while also answering your questions about employee benefits. If you’re already wrapped up in a non-compliant plan, we can help you figure out if you should contact the IRS about the Section 125 plan voluntarily.
Our tax attorneys can also negotiate with the IRS on your behalf to resolve any existing payroll tax matters. You can reach us online or by calling (404) 233-9800 to schedule a consultation.
Section 125 Cafeteria Plan FAQs
Why are Section 125 plans called cafeteria plans?
Because they allow employees to pick and choose from several types of benefits, just like an individual might choose among different types of food in a cafeteria.
What’s the difference between a premium-only plan (POP) and a Section 125 plan?
A POP plan is a type of cafeteria plan that allows eligible employees to pay for part of their health insurance premiums using pre-tax dollars.
What’s the difference between a Section 125 plan and a cafeteria plan?
A cafeteria plan is a plan that lets employees choose from multiple benefit options. A Section 125 plan is a plan that meets the requirements of Section 125 of the Internal Revenue Code. All Section 125 plans are cafeteria plans. Most cafeteria plans are classified as Section 125 plans – unless the plan doesn’t meet the legal requirements.
