Section 125 plans are perfectly legal, as long as they’re set up and administered properly, but if they’re not, they can lead to serious problems, including disqualification by the IRS. If this happens, the IRS can retroactively disallow the tax-free treatment of the deductions.
As a result, all pre-tax deductions get reclassified as taxable wages, and both the employer and employees get an unexpected tax bill that includes back employment taxes, plus penalties and interest. Read on to learn more about why this happens, and if you have concerns about what to do if this happened to your organization, contact Wiggam Law today.
Key Takeaways
- Section 125 problems – Section 125 plans sometimes aren’t set up or operated properly because they allow automatic reimbursements, insufficient verification of claims, or lack proper documentation.
- Plan problems could lead to reclassification – If the IRS finds significant problems with a Section 125 plan, it has the authority to reclassify some or all of the past pre-tax plan deductions as taxable wages.
- The reclassification can go back years – The reclassification can go back years, possibly to the point when the deductions first started.
- Consequences of reclassification – The employer and employee could be liable for back employment taxes, plus penalties and interest.
- Proactive action is key – To avoid and minimize reclassification risks, an employer should review its payroll practices with the help of a Section 125 tax professional.
Why the IRS May Reclassify Deductions as Taxable Wages
Not all flaws or issues with a Section 125 plan will result in the reclassification of Section 125 deductions, but it’s a strong possibility, especially if the plan:
- Allows participants to self-substantiate their health, wellness, or dependent care expenses.
- Only verifies a limited number of claims, such as only those of a certain dollar amount or those chosen using a sampling method.
- Doesn’t require third-party verification for claims.
- Permits debit card charges to be automatically substantiated because they originated with a preferred health care provider.
- Reimburses dependent care expenses before the employee actually incurs the expense.
- Lacks necessary plan documents.
These types of issues can be found when the IRS completes an audit. These discoveries could occur during a general business audit, as well as a payroll/employment tax or Section 125 plan audit.
How Far Back Can the IRS Reclassify Deductions?
If the IRS decides to treat pre-tax deductions as taxable income, it will usually make these changes following the completion of an audit. Generally speaking, the IRS will only conduct a payroll audit that goes back three years from the date of the return being audited.
However, the IRS may go back six years if the return was missing a significant amount of income. And there’s no time limit if the IRS is auditing your business for a tax year where you didn’t file a valid and required return, or the return filed was fraudulent.
Even though an audit might only go back a few years, if the IRS determines a plan was improper from its inception, all deductions taken under that plan are invalid. However, the IRS can generally only assess back taxes and penalties for years that are still open under the statute of limitations.
Consequences of Wage Reclassification
The IRS reclassifying deductions as wages means bigger tax bills for the employer and employee for unpaid taxes, as well as penalties and interest.
Unpaid Taxes
The employer and the employee will be responsible for unpaid payroll taxes on the amounts that were wrongly classified as deductions and not taxable wages.
The employee will also be responsible for unpaid income taxes on the pre-tax amounts withheld from each paycheck that were used to pay for plan benefits.
Penalties and Interest
An employer could be liable for the failure-to-deposit penalty. The IRS may also assess failure-to-pay penalties on both the employer and the employee based on unreported income.
On top of taxes and penalties, the IRS will charge interest, which can vary each quarter. The IRS will sometimes waive penalties, but the IRS only waives interest in cases where the underlying tax or penalty was abated or in situations where the interest was due to erroneous written advice from the IRS.
Additional Problems for an Employer
Besides the above costs, the employer could also face fines from the U.S. Department of Labor, as Section 125 plan violations may have also violated other federal laws, such as ERISA (Employee Retirement Income Security Act).
Possibly the worst thing for employers will be dealing with angry employees who got a surprise tax bill from the IRS. Depending on their income, the amount of the deductions, and how far back the IRS reclassifies deductions as wages, employees might have unmanageable tax bills. These could be large enough that the employees have to consider setting up an installment agreement or negotiating with the IRS to find some other resolution to a tax bill they can’t immediately pay off in full.
Example of How Reclassification Works
To give you an idea of the potential tax problems you can face if the IRS reclassifies tax-exempt Section 125 deductions as wages, let’s work through an example.
Say you have $500,000 in Section 125 deductions reclassified as wages. Here are the potential penalties and interest:
- FICA taxes for employees: $38,250 based on a 7.65% FICA tax rate.
- FICA taxes for employers: $38,250 based on a 7.65% FICA tax rate.
- Income taxes for employees: Variable based on income tax rate, potentially between $0 and $185,000.
- Penalties for employers: Failure to deposit penalties range from 2 to 15%, so up to $5,737.50.
- Other penalties for employers: Failure to file or pay penalties up to 25% each or $9,562.50, and accuracy-related penalties can be up to 20% or $7,650. Fraud penalties can be up to 75% or $28,687.50.
- Interest backdated to the original return due date: $3,283 in the first year alone, based on a 7% interest rate compounding daily. But note that the number only includes one year and doesn’t include interest on penalties, so the actual interest is much higher. The IRS adjusts its interest rate quarterly based on the Fed Rate plus three.
What Employers Can Do
If you’re worried about the possibility of deduction reclassification, there are a few things you can do:
- Carefully review plan documents and Section 125 requirements to see if there are any clear red flags that might draw the attention of the IRS.
- Halt questionable deductions.
- Confirm the existence and location of payroll and plan records in case they’re needed for an audit or examination by a payroll tax professional.
- Consult with a tax attorney with Section 125 experience.
Whatever you decide to do, the sooner you take action, the better. If you find a problem and voluntarily address it before the IRS contacts your organization about it, you improve your chances of limiting the penalties or avoiding plan disqualification. Quick action also offers more flexibility in how to proceed. Waiting for the IRS to contact you means you’ll largely be limited to doing only what the IRS specifically asks you to do and only on the IRS’s timetable.
FAQs About Reclassifying Deductions as Wages
Why does reclassifying deductions increase payroll taxes?
Section 125 deductions are tax-free. That means, they are not subject to FICA taxes (Medicare and Social Security taxes) and excluded from the employee’s gross income. If the IRS reclassifies the deductions as wages, employees are responsible for their half of FICA taxes, while employers are responsible for a matching payment.
Why does reclassification create tax liabilities for employees?
Once the deductions are reclassified as wages, they are subject to FICA taxes and income taxes. Employees are responsible for their half of the FICA taxes plus income taxes.
Should I issue new tax forms to employees?
Talk with a tax attorney to figure out the best steps forward in your situation. You may need to issue corrected W-2 forms to employees or amend returns filed with the IRS. However, you should not take these steps on your own without the right guidance.
Avoid Retroactive Reclassification of Deductions as Wages
Section 125 plans are popular, yet not the simplest workplace benefit plans to implement or operate. Therefore, the IRS knows that these cafeteria plans are a prime target for noncompliance and isn’t afraid to retroactively reclassify incorrect Section 125 deductions as taxable income.
Should the IRS take this action, it’s usually the employer and employees who are on the hook, not the vendor that set up the plan.
Don’t get caught with a non-compliant Section 125 plan, as it could cost your business more than money. Whether you’ve found a problem with your plan or you want to make sure it’s compliant with IRS rules, the tax pros from Wiggam Law can help. You can reach us online or by calling (404) 609-1300 to set up a consultation.
Sources
– https://www.irs.gov/businesses/small-businesses-self-employed/irs-audits
– https://www.irs.gov/taxtopics/tc305
– https://www.irs.gov/businesses/small-businesses-self-employed/how-long-should-i-keep-records
– https://www.irs.gov/pub/irs-pdf/p5137.pdf
– https://www.irs.gov/businesses/small-businesses-self-employed/understanding-employment-taxes
– https://www.irs.gov/payments/failure-to-deposit-penalty
– https://www.irs.gov/payments/underpayment-of-estimated-tax-by-individuals-penalty
