Some employers learn that their Section 125 plans are abusing IRS rules after getting contacted by the IRS or following an IRS audit of their benefit plan. In other cases, the employer might learn of a potential problem on their own. In this latter situation, a question arises as to whether it’s better for the employer to preemptively fix the issue or if it makes more sense to wait until the IRS brings it up.
The short answer is that it’s usually better to voluntarily fix the problem – but to protect yourself, you may want to reach out to legal counsel first. The goal of this blog post is to further explain how and why a proactive response tends to be the best. If you have an organization that might have a problem with its Section 125 plan, don’t wait – contact the tax and payroll professionals of Wiggam Law now.
Key Takeaways
- Plan problem discovery – Employers can learn of potential problems with their Section 125 plan in a variety of ways, including employee questions, internal review of financial records, or IRS contact.
- Prompt action is important – In almost all cases, acting proactively to address plan problems is better than waiting for the IRS to contact you about it.
- Benefits of acting quickly – Making a good faith effort to preemptively fix the Section 125 plan can reduce unpaid tax bills and penalties, reduce the risk of civil liability, provide greater flexibility in responding to the problem, and minimize the chances of plan disqualification.
- Hiring a tax professional is important – A tax professional with Section 125 experience can help navigate the complex process of fixing any issues and getting things squared away with the IRS.
How Employers Learn About Section 125 Plan Problems
Ideally, an employer can avoid a questionable Section 125 plan by spotting one or more red flags before signing up for the plan. If this doesn’t happen, the employer will typically learn about the lack of compliance months later – here’s how:
- An accountant or payroll manager notices inconsistencies in payroll numbers.
- Someone in human resources comes across benefit reimbursement errors, including payments made without necessary verification.
- Employees ask questions (or complain) about unexpected withholdings from their paychecks.
- The vendor for the benefits plan can’t answer certain questions about the cafeteria plan or provides evasive responses to inquiries from the employer.
- The IRS contacts the employer about a potential problem with their income and employment tax withholdings.
- The IRS conducts an employment tax audit that uncovers potential problems with the benefits plan.
How the Employer Should Respond to the Discovery
In the majority of situations, if the employer learns of a mistake in the cafeteria plan’s administration or operation, the employer should take necessary steps to bring the Section 125 plan, the employer, and plan participants to the position they should be in had the error or mistake not occurred. How this is done will depend on many variables, including the nature of the flaw, how much money is at issue, who’s been affected, and why the error happened.
One exception to this guidance is if the problem with the Section 125 plan stems from potential criminal conduct by the employer or its employees. In this case, there’s potential that taking proactive steps to address the situation could include incriminating conduct and serve as evidence in a future criminal prosecution. In this rare situation, the employer should immediately hire a tax attorney with experience handling criminal cases before taking any substantive action with the cafeteria plan.
At a minimum, the employer should review payroll records and Section 125 plan documents, then consult with a payroll or tax professional with experience handling cafeteria plans.
Why Employers Should Respond Proactively
Tax and payroll problems are like most other problems in life: they’re easier to deal with the sooner they’re discovered. Here’s why it’s critical to be proactive.
Financial savings – stop the bleeding ASAP
The sooner you take action, the less money you’ll have wrapped up in a problematic plan. For example, the cafeteria plan at issue might be improperly making payments for FSA plan benefits. This mistake is far easier to deal with if only a few payments worth a few hundred dollars have been made, compared to hundreds of payments amounting to tens of thousands of dollars or hundreds of thousands of dollars.
Employee confidence – preserve their trust.
Being proactive can also reduce the risk of upset employees who might get mad that they’re no longer eligible for health benefits they enjoy. Allowing such a mistake to continue for an extended period of time reduces the confidence and trust employees have in their employers.
Tax exposure – act fast to limit your liability.
Another advantage of fixing plan issues quickly is that it can limit tax liability exposure. If insufficient funds have been withheld from each paycheck for income and employment taxes, the longer those incorrect withholdings continue, the bigger the tax debt will be. This can often lead to bigger penalties and more interest that the employer is liable for.
More flexibility – the IRS is easier to work with if you contact them
Finally, acting early offers greater flexibility in addressing the issue. If an employer waits until the IRS contacts them, the employer likely has no choice but to do exactly what the IRS asks and on a timetable of the IRS’s choosing. The employer can also expect other negative consequences by waiting too long to act.
What Could Happen if an Employer Doesn’t React Quickly
If an employer decides to wait before taking action, that will increase any tax liabilities they face, including penalties and interest. Depending on the nature of the plan’s flaw, it could also result in the entire benefits plan being disqualified.
If the IRS disqualifies a plan, the IRS could treat the employer and employees as if no benefits plan existed. This could result in the IRS retroactively reclassifying the Section 125 plan deductions as taxable wages. Then the employer and employees have to pay back income and employment taxes (plus penalties and interest) for the plan contributions.
Even if the delay doesn’t somehow result in a bigger tax bill for the employer or the employees, it will make fixing the situation more difficult with a greater volume of inconsistent and incorrect payroll and tax records. This may require the employer to file a greater number of amended tax filings.
- Don’t forget that problems with Section 125 plans could also break other federal laws, such as ERISA (Employment Retirement Income Security Act),
- HIPAA (Health Insurance Portability and Accountability), and
- COBRA (Consolidated Omnibus Budget Reconciliation Act).
This could lead to additional penalties, as well as civil suits. Acting as soon as practical demonstrates good faith, which could limit or reduce this added legal and financial liability.
Good Faith Actions Matter
The IRS and other government agencies have enforcement responsibilities to protect employees and uphold federal law, such as the Internal Revenue Code. But these agencies also understand that mistakes happen and there’s little benefit to punishing employers and employees for honest mistakes, especially when attempts to remedy those mistakes are made as soon as they’re discovered.
For these reasons, an employer that engages in good-faith attempts to fix a problematic Section 125 plan will likely face smaller penalties and civil liability than if it knowingly allowed problems to persist. The IRS exists to collect taxes, not punish taxpayers for honest mistakes.
One last thing to keep in mind is that, compared to other tax violations (such as retirement plan errors), the IRS doesn’t have as well-established protocols in place for dealing with non-compliant cafeteria plans and what employers must do to fix them. Put another way, there’s a little bit more leeway in how the IRS handles these situations.
This means the more an employer tries to “do the right thing,” the more discretion the IRS or government agencies have to reduce or minimize any punishments. This makes it even more important to seek the guidance of a tax pro when an employer discovers a problem with its Section 125 plan.
Professional Tax Help for Questionable Section 125 Plans
If you or someone at your organization thinks there could be an issue with your Section 125 plan, consult with an experienced Section 125 tax professional sooner rather than later. They can help you examine plan documents and payroll records to confirm compliance with relevant federal statutes and regulations. And if problems are found, advise you on the best way to fix them.
Take the first step in ensuring your cafeteria plan follows the proper rules by contacting Wiggam Law. You can schedule a consultation by calling (404) 609-1300 or using our online contact form.
FAQs About Voluntarily Fixing Section 125 Plan Problems
Should I use the IRS Voluntary Disclosure Program if I’m using a non-compliant Section 125 plan?
Generally, no. The IRS’s Voluntary Disclosure Program is for criminal tax actions. However, state voluntary disclosure plans, including the one in Georgia, are generally not focused on criminal issues. Before using either federal or state voluntary disclosure programs, contact a tax attorney.
Will the IRS assess penalties if I come forward voluntarily?
Yes, you may still face penalties for non-compliance even if you come forward voluntarily. But you can often minimize penalties (for example, by requesting penalty relief due to reasonable cause) if you come forward voluntarily.
Am I responsible for Section 125 abuse?
Unfortunately, yes, as an employer, you are responsible for the benefit plans you implement. That’s true even if you were misled by an unscrupulous promoter. However, an experienced tax attorney can help you make a plan and minimize the consequences.